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

33 Table 2.4: Capital and RWA (in SRD thousand) and the BIS ratio under Basel I ( ) Regulatory Capital 194, , ,182 Risk weighted assets 1,879,460 2,415,521 2,657,106 Solvency ratio 10.4% 9.8% 10.8% Source: Central Bank of Suriname The Central Bank of Suriname has also calculated the Tier 1 capital (this is core capital) against the risk weighted Assets, which are: - Year 2007: Tier 1 / Risk Weighted Assets of 8.8% - Year 2008: Tier 1 / Risk Weighted Assets of 8.4% - Year 2009: Tier 1 / Risk Weighted Assets of 9.5% In the next figure the BIS ratio is presented and compared to the benchmark. Also the relationship between Tier 1 capital and the risk-weighted assets are expressed. BIS ratio based on Basel 1 12% Percentage 10% 8% 6% 4% 2% Benchmark (Minimum) BIS Ratio Suriname Banking Sector Tier 1 / Risk Weighted Assets 0% Year Figure 2.7: BIS ratio, Tier 1 and minimum capital requirement under Basel 1 ( ) Source: Central Bank of Suriname As illustrated in the above figure, the Surinamese banking sector in general complies with the Basel I regulation, where the solvency ratio is higher than the norm, which is determined by the Basel Committee of 8%. This statement indicates that under Basel I there is sufficient capital available in order to cover the credit risk. Furthermore, based on Tier 1 capital only, the Suriname banking sector is well above the Basel solvency norm. 24

34 CHAPTER 3 LITERATURE REVIEW CONCERNING BASEL II 3.1 INTRODUCTION In this chapter a theoretical analysis will be presented regarding the Basel II regulation for credit risk. The two approaches, namely standardized approach and internal rating based approach will be discussed. Debates concerning these approaches, the effect of these approaches on bank capital and risk weighted assets, the shortcomings of these approaches will be outlined in this chapter. At the end of this chapter is stated which approach is better in order to determine the capital requirement. 3.2 CREDIT RISK APPROACHES WITHIN BASEL II IN GENERAL The Basel Committee has developed several approaches in order to determine the capital requirement for credit risk. One of the approaches is the standardized approach, which is a revised version of the Basel I framework concerning credit risk and the other approach is the internal rating based approach, which is the main innovation of the Basel Committee concerning calculating capital requirement for credit risk. The capital requirement within Basel II for credit risk will be based on rating that will be assigned to the borrowers. Assigning rating is considered in the standardized approach, as well as the internal rating based approach. The major difference between the two approaches for calculation capital charges for credit risk is that rating within the standardized approach is determined by an external rating agency, while the internal rating based approach is based on internal assessment of the bank itself. Due to this difference Van Roy (2005) indicates that large banks within G-10 will implement the IRB approach. The reason behind this is that banks have to develop there own internal ratings for determining the risk weighted assets and in order to use this approach specific criteria, as developed by the Basel Committee, should be met together with the approval of supervisors. Small and medium banks in the G-10 and other countries, e.g. developing countries, will 25

35 concentrate on the standardized approach due to their accounting and information weakness (which means data availability needed for using the IRB approach). Illing and Paulin (2004) did a further research on banks within G-10 and have shown that capital requirement under the standardized approach will increase, but under the IRB approach will decline. These authors have also indicated that within both approaches the risk weight of a specific risk category will certainly vary over time. Therefore capital requirements under Basel II will be more volatile. Capital requirement for credit risk under Basel II are more risk-sensitive than the Basel I regulation, which means that increase in capital is greater if the quality of the loan portfolio is low. The capital charges for credit risk will also increase if credit is being evaluated based on how the assessment is being done concerning assigning ratings to borrowers. Furthermore, Illing and Paulin (2004), Gottschalk (2010) and Sen (2005) indicate that since defaults and loan losses are countercyclical, it is expected that capital under Basel II will also be countercyclical in both approaches of Basel II; for example, capital will increase in time of recession and decrease in economic upturns. In order not to get volatility in capital, banks will more likely adjust their credit portfolio. What this means is that if the credit risk sensitivity of the new regulations leads to changes in capital, which are unacceptable by banking institutions, they will probably adjust their lending. So, there will be a decrease in lending, which will lead to a decrease of the credit portfolio. This will further lead to a decrease in RWA, which is a big concern of policy-makers regarding procyclicality. Sen (2005) and Gottschalk (2010) also mentioned that the new regulations could grant competitive advantages to domestic banks as well as international banks, because if the domestic jurisdiction has the possibility of calculating the capital requirement based on all the three models (standardized / F-IRB / A-IRB), the banks that are using the IRB approaches will have a competitive advantage on other banks that are using the standardized approach in terms of capital requirement. IRB approach leads to a lower level of capital requirement (Griffith-Jones & Spratt, n.d.). If all three approaches are permitted it is obvious that the larger banks will choose for the IRB approach and the small banks will choose for the standardized model. This will lead to banking concentration in favor of the larger banks. Once it has been concentrated the larger 26

36 banks will typically lend to large companies. This leads to loan portfolio concentration, which simply means that granting loans will shift away from poor and SME towards large borrowers. This will be the case because of poor information available of the SME s and the Poor s and because of the risk measurement techniques, these groups will be judged as they are the group of higher risk compared to large borrowers (Gottschalk, 2010 & Sen, 2005). This once again indicates the result of the New Accord in developing countries, in order to comply with the minimum capital requirement. Griffith-Jones and Spratt (n.d.) have presented in their article that the New Accord is based on a small number of large banks that are internationally active. So the new regulations are developed based on focusing on the need of the major banks from the G-10. They have stated that the developing countries will face difficulties in order to get foreign loans due to the new regulations, because they will be indicated as being high-risk countries, which will have an effect on the capital requirement of the bank that will grant the loan. Furthermore, just like Sen (2005) and Gottschalk (2010), they have stated that the domestic banks will encounter a direct effect on their competitive position because of the three approaches that have been developed within the new regulations. Banks try to choose the best approach in order to decrease the capital requirement, but not all banks will be able to do that in the developing countries. Atkinson (2008) has indicated that Basel II is more based on empirical judgment of credits risk based on external rating agencies or based on their own internal analysis, but the general framework compared to Basel I has not changed. He states that perhaps due to this, the new regulation has also contributed to the financial crisis, which started in mid A lot of credit has been provided to residential real estate, for example, in the United States, which was the reason of the financial crisis, and major governments had to rescue by recapitalizing banking institutions. As indicated within Basel II the RWA for credit provided for residential real restate is 35% within the standardized approach, which probably led to underestimating risk and created a financial crisis, because lower capital was held than required. Furthermore, he stated that due to the fact that two approaches (standardized approach and internal rating based approach) have been developed to determine capital requirement for credit risk, there would be huge differences between banks concerning capital requirement. Those banks that qualify for the internal rating 27

37 based approach (where data concerning borrowers is a key element) will benefit from the Basel II regulations, because this approach leads to a decrease in capital requirement compared to the standardized approach. Goodhart and Segoviano (n.d.) have indicated that it is not clear what the Basel Committee wants to achieve through rating. The question they raised is: has Basel II been developed for measuring the probability of loss or has it been introduced to measure probability of loss and severity? After research it was indicated that Basel Committee tries to measure the probability of loss and severity, which again raises the question why risk weight should be assigned to sovereign and firm. Below a more detail analysis will be shown of the standardized approach and the internal rating based approach as determined within Basel II. 3.3 STANDARDIZED APPROACH FOR CREDIT RISK In chapter 2 is presented the calculation of the BIS ratio under the standardized approach. There are two options regarding risk weights for credits provided to banks. The risk weight under the first option is based on a level lower than of the risk weight assigned to credits provided to sovereigns. The second option shows the risk weights based on the external credit assessment of the bank itself in which short-term loans (less than three months maturity) have lower risk weight than long-term loans in each rating structure, except credits rated below B- where the risk weight is equal to 150%. Based on the above development concerning distinction between risk weight for short-term credits and long-term loans, Griffith-Jones and Spratt (n.d.) concluded that this distinction provides an incentive for banks to provide short-term loans to their customer rather than longterm credits, because for the short-term credits less capital is required in order to cover the credit risk. Griffith-Jones and Spratt (n.d.) just based their conclusion on the favorable risk weights that are being determined by the Basel Committee regarding short-term loans in which the banks rated from AAA till BB+ will use a 20% risk weights. 28

38 In an article of the Australian Federal Economic Chamber (as cited by Rooy, 2005) it has been stated that the two options concerning the risk weights for banking institutions can lead to a distortion of competition between countries. This means that the goal of Basel Committee concerning creating a level playing field will not be met. The competition can arise due to the favorable risk weights determined by Basel Committee through the second options in which less capital will be required than the first option. In this case option two will provide an incentive to the banks concerning capital charges, because less capital will be needed in order to cover the risk. Ferri et al. (as cited in van Roy, 2005) has performed a research and provided proof that between the two options for credits to banks, there are relatively small differences and in some cases it is statistically not significant to perform an analysis. Based on this statement concerning the two options, there will be no fundamental change in capital requirement and thus the above statement made by Griffith-Jones and Spratt, and the statement presented in the article of Australian Federal Economic Chamber is contradicted. Taking into consideration the analysis performed by the above authors, it is important that there is a distinction between long and short-term loan with differences in the risk-weight where a higher weight is assigned to long-term loan than the short term. The reason behind this is that for a short-term loan the bank will get their funds back within a period of 3 months. Furthermore, in most of the cases the loan amount for a short-term loan is lower than for a long term. Based on these two reasons it is important to make the distinction and assign different rates to these assets. These two reasons also indicate that in case of short term the risk is lower than in case of long term loans. Within the standardized approach it is stated that if there is no external rating agency in a country, regulators can use risk weights under the un-rated category. These risk weights are also determined by the Basel Committee with the focus on credits to sovereigns, banks and corporate. Griffith-Jones and Spratt (n.d.) and Sen (2005) have concluded that un-rated sovereigns, banks and corporate have been assigned a favorable risk weight than low rated sovereigns, banks and corporate. What this simply means is that less capital will be required to cover the risk based on 29

39 the risk weights determined under the un-rated category compared to capital charges under the low rated category. Griffith-Jones and Spratt (n.d.) and Sen (2005) further indicates that the effect of this will be that rated sovereigns, banks and corporate will give up their rating, in order to decrease the capital requirement. It is worth mentioning that credits to sovereigns, banks and corporate under the un-rated category do not mean that poor quality loans have been provided to these borrowers. Due to the fact that these borrowers are not being rated, because their risk cannot be determined, a 100% risk weight is assigned. In another study (J. Danielsson, P. Embrechts, C. Goodhart C. Keating, F. Muennich, O. Renault, & H. Song Shin, 2001) it has been indicated that the standardized approach is an improvement than the actual Basel I regulations, because it takes into consideration the differentiation of assets not only based on the borrower, but also the risk of the borrower is taken into account. Although this is indicated as an enhancement, there are several other problems within this approach. One of the biggest concerns is that the risk sensitivity, as far as corporations are considered, can only work properly if corporations are really rated and that the proper risk is reflected. So, this expresses that it cannot be shown which way capital requirement will move (is it going to increase or will it decrease). If firms are not rated based on the Basel II norm, there will be no change compared to the old accord (Basel I) because the risk weight is the same percentage for corporate loans. So for un-rated category no change will be noticed in capital under the new regulations. In the United Stated, for example, most of the firms are rated, so this approach can improve the capital allocation, but in Europe, for example, approximately 50% firms are rated, which will have low effect on the capital charges. Due to the fact that un-rated firms are connected to lower risk weights than firms rated BB- or below, this approach creates space for risky firms to move from being a rated firms towards un-rated firm in order to get cheaper finance. This will also affect the bank capital charges, because the risk weighted assets will decrease, which means that less capital will be needed to cover the risk. Atkinson (2008) has also presented in his study that the standardized approach creates space for banking institutions to form a regulatory arbitrage, which means that banking institutions will get the opportunity to free up capital by shifting credit portfolio from high risk weighted assets to low risk weighted assets. So, this indicates that the capital ratio can increase, because RWA will 30

40 decline due to favorable risk weights assigned by credits provided by the banks. This action can lead to an increase in leverage within the banking institution, which means that credits can be provided to customers without additional capital backing or the extra capital, which is available within the bank as owner s equity, will be returned to shareholders through, e.g., higher dividend payments, or at the same time the banks perform both (increase in credits and high dividend payments). The result of leveraging would mean that there is little equity capital available within banks for backing the balance sheet. Therefore Atkinson (2008) has stated that as long as the rating system exists, it will favor banks in order to maintain low risk weights with huge impact on the equity capital of these institutions. A real example concerning the above is Europe. Analysis by Atkinson (2008) shows that the balance sheet of commercial banks in Europe has increased much faster than equity, which means that equity backing for the assets, has been lowered. On the other hand the opportunities created by Basel II concerning free up capital make bank behave as they have excess equity capital, therefore instead of adding this excess capital to its retained earnings in order to increase its capital buffer (Tier 1 capital), these banks have chosen to return it to shareholders in the form of higher dividends or share buybacks, which means that banks were buying there share back form their shareholders that led to a decrease in capital. Van Roy (2005) at the other hand also did an analysis concerning favorable rating. In his analysis he indicated that if banks adjust their lending policy to borrowers with favorable ratings (moving from high risk weights to low risk weights), there would be small change (decreases) in their capital requirement under the standardized approach. What he also mentioned is that capital requirement for corporate, banks and sovereigns will be higher if it is being compared to the calculation based on Basel I. Van Roy (2005) has also performed an analysis at the EMU countries concerning rating assigned to borrowers by an external credit assessment institution (ECAI) under the standardized approach. Local supervisors are assessing these institutions on the validation and recognition, but banks can determine for themselves which external credit assessment institution they like to use in order to determine the regulatory capital requirement. Although these ECAI are assessed conform criteria of Basel II regulation, namely objectivity, independence, international access/ transparency, disclosure, resources, and credibility (these criteria are based on those of the US Securities and Exchange Commission) the several ECAI 31

41 will create an issue concerning the reliability of the capital requirement, because different ECAI will lead to differences in capital requirement. The reasons as indicated by Van Roy (2005) are that credit ratings are a subjective assessment of the borrowers probability of default. Several ECAI will have differences in rating borrowers due to the fact that they differ in opinions, methodology, rating scale, etc. If there is a difference in rating, based on the standardized approach, there will be difference in regulatory risk weights (as determined by Basel Committee), which automatically creates differences in capital requirement. Furthermore, Van Roy (2005) indicates that ECAI has not the same coverage across countries and rating markets. Due to this, differences in capital requirement will be created, because borrowers, which are not rated, are assigned a better risk weight compared to low rated sovereigns, banks and corporate as indicated in the standardized approach. Danielsson et al. (2001) shows also that external credit agencies provide inconsistency in the creditworthiness of the same firm. Credit rating agency provides some assessment of company s risk and generally lags to include market developments. They only focus on financial data and are unable to monitor all borrowers continuously, which means that ratings are not being changed on time. Due to this it is difficult to verify if the capital requirement is enough in order to cover the actual risk. Powell (2006) did a study on emerging economies and stated that this approach does not really result in aligning regulatory capital with the determined risk. The reason behind this is that countries will have difficulties in penetrating to ratings of Moody s, Standard & Poors and Fitch. In emerging economies the local external rating agencies publish ratings based on the local scale. The issue that arises is which rating should be used (international homogeneity ratings, which limits the availability of rating or local ratings which cannot be compared to international ratings) Ferri (2000) indicated that external credit rating agencies would lead to an increase in the volatility of banks capital requirement and cost of capital. This will affect the availability of credits and the cost of credits negatively. Volatility in bank capital can occur due to the differences in rating provided by the external rating agencies. If the demand for capital increases, 32

42 a higher price has to be paid for the additional capital required. Therefore banking institutions will have to include the higher price in determining the pricing for credits, which in this case will increase. Due to the higher price for additional capital, demand for credits will decrease. Kirstein (2002) on the other hand, has stated that it is expected that the Basel II regulation will lead to a decrease in capital requirement compared to Basel I. In his research he concentrated on the banking institutions in Germany and indicated that the German Bank sees external rating as a threat in providing credits. The reason behind this is that there are only a few firms in Germany that hold a rating and the banks have a close relationship with their customers. The latter indicated that the German Banks have better knowledge than external agencies have and thus ratings can differ, which will influence the capital requirement. Based on his research Kirstein (2002) came to the conclusion that external rating realizes the goals of the Basel Committee through Basel II in a better way than the internal rating based approach, which will be outlined in the next section. As long as supervisory authorities do not measure internal rating, internal based methods will not implement the goals of Basel Accord. In such a case, banks will have the incentive to assign a rating that deviates from the internal result and influences the required capital in a positive direction, which means less capital charges. From the analysis above, ratings will obviously lead to changes in capital requirement. These ratings can be influenced based on data available, the method that is being used to determine the rating, etc. Therefore, favorable rating could be assigned, which will lead to decreases in capital requirement. Furthermore, there are risk weights assigned of more than 100% for rating Below B- and in some cases below BB-. This means that the capital required for these groups will be more than the outstanding loan amount. How can this be possible that more capital should be assigned? If a loan is in default for the full amount, the maximum the bank will lose is 100%. So, a risk weight of 150% is unnecessarily increasing the pressure on bank s capital. Another issue, which should be addressed, is that in most cases under the un-rated category a risk weight of 100% is used. As already indicated this does not mean that loans provided under the 33

43 un-rated category are bad loans. Surely there are good loans, but because the sovereigns, corporate and banks are not being rated, they are assigned a risk weight of 100%. The Basel Committee could have taken into account that although there is no rating taking place, a distinction still can be made based on simple data in good borrowers, Past Due Overdrafts (PDO), which means that the customer has payments due of maximum 3 months, and Non- Accruals (also known as Non Performing Loans), which means that the customer has a past due of greater than 3 months. Based on these simple indicators the Basel Committee could have determined the risk weight under the un-rated category. Van Laere, Baesens and Thibeault (2007) have indicated that due to the simplicity of the standardized approach only small and medium banks will implement this approach. Despite the adjustment made compared to Basel I, the new regulation still contains insufficient differentiations between borrowers, because based on the risk-weights for the different type of credits, capital requirement for corporate loans remains high compared to the non-investment group. As indicated in chapter 2 the risk weight for corporate loan is 100%, while for retail the risk weight is 75% and for mortgage loan 35%. Atkinson (2008) has expressed that residential mortgages and credit to retail customer will favor banking institutions to free up regulatory capital. This is being indicated because for the residential mortgages and retail loans a risk weight of respectively 35% and 75% is being assigned compared to Basel I where a risk weight of respectively 50% and 100% was being assigned. This, for example, led to a decrease in capital requirement in the United States for mortgages of maximum 90% and as has already been indicated the root of the financial crisis was mortgage loans started in the United States of America The last remark, which also needs to be made, is that for retail loans a risk weight of 75% is being indicated. Chris Terry (2009) has indicated in his analysis that retail loans are less sensitive to systematic risk compared to corporate loans. This can be true, because failure of one company can have an effect on another company. But, the main thing that should be mentioned is that Basel regulation is about risk. Retail loans are loans, which are, in most cases, unsecured, so the whole portfolio should be assigned a 100% risk weight. Corporate loans, on the other hand, are 34

44 in most cases provided based on collateral. Here the risk weights should have been lower, because there are collaterals through which the loan can be covered. Furthermore, the 35% risk weight for claims on retail secured by residential properties depends on the banking and economic environment of the country itself. Based on this it can be determined if the 35% risk weight is low or not in a country. 3.4 INTERNAL RATING BASED APPROACH As indicated earlier the Basel Committee has developed two approaches in order to calculate the capital requirement concerning credit risk. The standardized approach has already been described above. Below a review will be given concerning the internal rating based approach. The internal rating based approach is just like the standardized approach based on rating. The difference is that the standardized approach calculated the capital requirement through ratings determined by external credit rating agencies, whereas ratings within the internal rating based approach are determined by the bank itself. Raghavan (2004) indicated based on his research, that large banks of the member countries of Basel Committee, as well as banks of other European countries, have a decrease in capital adequacy based on IRB approach in comparison with the Basel I regulation and standardized approach. As already stated, Van Roy (2005) did his analysis on the standardized approach but noted that IRB can also be explained through his analysis. This statement was based on research performed by Carey (as cited in Van Roy, 2005) who found huge differences between the internal ratings of 20 banks. Jacobson et al. (as cited in Van Roy, 2005) also found differences in two Swedish banks that use the internal rating based approach. The reason for the differences, as indicated by Van Roy (2005), could be due to the type of rating model which is being used or the moment when rating is provided. Furthermore, banks that like to use the IRB approach also benchmark themselves with the external rating agency and as indicated there are differences in the external assessment, therefore differences will occur in the internal rating based approach. If there are 35

45 differences in rating for the same loan, this automatically influences capital requirement for credit risk. Atkinson s (2008) analysis was also performed for the Internal Rating Based approach, which is the invention of Basel II. Through this approach, Atkinson stated that different banks could treat the same loan differently, because risk analysis and default probabilities are based on the assessment of the individual banks. Due to this there will certainly be differences in capital requirement for the same credit. Furthermore, Atkinson (2008) indicated that the formula (see appendix II) used in order to determine the capital requirement and risk-weighted assets are based on a mathematical model, which is the portfolio invariant model. What this model simply indicates is that capital required for a given loan must only depend on the risk of that loan and not on the portfolio (Atkinson, 2008; Van Laere, Baesens and Thibeault, 2007). So, it means that it ignores the effect of diversification on the portfolio (the effect of the specific loan is not taken into consideration in order to determine the effect on the portfolio). The effect of this is that it will reduce capital requirement, because the focus is just on the risk of the specific loan only. Benink and Kaufman (2008) have also questioned the IRB approach. They indicated that the recent financial crisis raises questions concerning the usefulness of the Basel II regulations. It has been indicated that recapitalization has to taken place in order to save banks and the financial system due to the fact that the internal model concerning determining credit risk has performed, in most cases, very bad and underestimated the credit risk leading to decrease in capital requirement. The invention of Basel Committee, namely IRB approach, provided banks the opportunity to assess the credit risk and determine the needed regulatory capital, but banks have under estimated the risk exposure in order to decrease the required regulatory capital. It has been indicated in The bank capital adequacy (2008) that Citi Bank did a research concerning the equity capital of the European banks. In this research it was explained that the tangible equity of European banks has been weakened, whereas there Tier 1 capital has been increased. This raises question because equity capital is the core of Tier 1 capital, so if equity capital has been declined than how did Tier 1 capital increased? This has been explored and the increase in the Tier 1 capital was due to the fact that hybrid equity was introduced and increased 36

46 the capital heavily in these countries. In the same research it was also stated that the denominator, namely the risk weighted assets of the same European banks, had been decreased (credit risk declined), although their assets increased. In depth analysis shows that the decline in the RWA was realized by the implementation of Basel II. This New Accord gives banks, through the IRB approach, to much space for determining the rating of borrowers, which influence the risk weight that has to be assigned to the credit. If favorable rating and risk weights are assigned than this will decrease the capital requirement needed to cover credit risk. Powell (2006) said that this approach is a black box, which is difficult to implement because it depends on the circumstances within the country. It is a very complex model, which has been developed and gives the banking institutions full autonomy to determine the rating for borrowers by themselves. This can create difficulties for supervisors to verify the reliability of such a rating provided to the credits and more the rating system as well. Furthermore, it has been indicated that in order to use this approach, data is very important. Powell s analysis was done for emerging markets and the result of his research was that not all data needed to use the IRB approach is being published. This means that banks in these countries will not be able to implement this approach in these countries. Furthermore, Powell (2006) presented that internationally active banks in emerging markets might be asked to implement the internal rating based approach, while locally active banks will adopt the standardized approach. This distinction will create an uneven competition in the emerging markets. It will be disadvantage for the international active bank because lending to SME will be a big issue for them. They will not be able to provide credits to small medium enterprises because they need data of these companies in order to determine the rating and as indicated this data is not available. In the article Meeting the Basel II solvency requirements (IRB approach) for Volkswagen Bank GmbH (n.d.), it has been stated that for implementing the internal rating based approach banks have to face tremendous IT challenges. The reason for this is that in order to use this approach a lot of data concerning the borrowers should be captured by banking institutions. It is about retrieving data, monitoring data, improve data quality, assurance concerning availability of reporting. If the data is not available, it will become difficult for banks to use this approach and the capital gain will not be realized. 37

47 Van Laere, Baesens and Thibeault (2007) have also indicated that under the IRB approach data is very important, because the IRB approach is much more risk sensitive and it differentiates much more in credit risk. Therefore, the important item under the IRB approach is reliability of data. Banks that want to use the IRB approach should convince regulators that their system is sufficiently sophisticated. If the data is not available the benefits of the internal rating based approach, which is a decrease in capital requirement, will not be realized. Another concern of this approach is procyclicality. Goodhart and Segoviano (n.d.) have stated that procyclicality is a big concern due to implementation of Basel II regulations. Banking institutions normally keep their capital buffer above the minimum required by local authority to cover credit risk and will increase this buffer during down times when capital requirement under internal rating based approach may decrease below levels. So, what Goodhart and Segoviano are indicating is that when the economy is moving upwards, the capital requirements under the internal rating based approach will decline, because borrowers are being assigned a favorable rating. On the other hand, the same companies will face a decrease in rating (lower quality of rating) in times when the economy is not performing well, which leads to an increase in the capital requirement of the banking institutions. Furthermore, Goodhar and Segoviano (n.d.) have explained that in case a bank decides to moves from the standardized approach to the internal rating based approach, the bank will be encouraged to shift its credit portfolio to a higher quality. This indicates that a higher credit rating will be assigned to the credits of the banks, because this is the only way that the banks will benefit from the low capital requirement determined by the internal rating based approach. This action of the banks will lead to an enhancement in the procyclicality as described above and effect the capital requirement. Atkinson (2008) also mentioned that the Basel II regulation increases the effect concerning cyclicality as described above, but his analysis is not only based on the internal rating base approach. In both cases, whether risk weight depends on rating assigned by external agency or determined internally by the banks, in economic upturns banks risk will decrease and capital requirement will decrease. This result provides banks the incentive to take more risk because capital is available to cover the extra risk. In economic downturns the credits risk will increase, 38

48 therefore capital is not enough to cover the risk. The next action of the banking institutions will be on the credit portfolio. In this case banks will lower their credit portfolio, which indicates that credits will decrease. Jacobson, Lindé and Roszbach (2005) have researched the special treatment, which is given to credits provided to retail customers and SME under the internal rating based approach within Basel II. It has been indicated that the reason for this special treatment is that credits to these types of customers (retail and SME) are less sensitive to systematic risk and thus leads to less capital requirement. This is also stated by Van Laere, Baesens and Thibeault (2007). The thought is that credit risk is only related to the individual loan and due to this the effect on other loans will be weaker compared to credits provided to corporate customers. Another reason is more of technical, because credits to retail customer and SME have a shorter maturity. In calculating the capital requirement maturity date has a key role. This is being indicated, because in the formula used to determine the capital requirement for retail loans, the maturity factor is not being taken into consideration, whereas for corporate loans it is indicated in the formula (see appendix II). The results presented by Jacobson, Lindé and Roszbach (2005) is based on data analysis of two banks in Sweden and shows that credits to SME and retail customers are not less risky loans compared to corporate loans as being indicated by Basel Committee. Their findings indicate that the loss rate could be smaller for SME compared to corporate but this difference is based on the definition for SME given by different banks and the portfolio size, which is taken into consideration. Their results show that the expected and unexpected losses are higher for SME and retail customer compared to corporate banks, therefore more capital is required for these credits and thus the special treatment as described by Basel II is not necessary. Griffith-Jones and Spratt (n.d.) noted that the IRB approach provides more flexibility to measure credit risk because banks are determining the risk itself and assigns rating to the credits. This flexibility give banks an incentive to change their approach based on guidelines of the regulators. The internal rating based approach can significantly influence bank lending in a negative way and / or can lead to an increase of cost. Research of Griffith-Jones and Spratt (n.d.) indicates that there will be an increase in loan of banks, which are rated triple B and above, but a decline in loans of banks rated below triple B. This indicates that banks rated triple B and above will have a 39

49 lower cost for credits, due to better ratings for credit while for banks rated below triple B the cost of credits will increase, therefore decrease in loans. So as ratings will decrease, the capital requirement will increase, therefore the concentration of the banks will be on lending to low risk borrowers. Griffith-Jones and Spratt (n.d.) stated that the reason behind this is the way the risk weight has been determined by the Committee through the internal rating based approach. The Basel Committee has used an exponential rather than a linear approach in determining the risk weights. The calculation of the capital required under this approach is based on an assumption, which is that the systematic risk is normally distributed. Van Laere, Baesens and Thibeault (2007) further indicated that the internal rating based approach of Basel II ignores the potential relation between PD and LGD. Within the regulation it is indicated that expected losses is a function of PD ad LGD. In order to calculate the capital requirement under the internal rating based approach these losses are subtracted and only unexpected losses are being taken into account. This action of the Basel Committee has created the fact that capital requirement under the internal rating based approach is underestimated. Based on the analysis performed by the different authors this approach will certainly lead to a decrease in capital compared to the standardized approach, because banking institutions will themselves determine the risk. So the actual risk will be taking into account. The biggest concern regarding this approach is how reliable will the calculation be, because the bank itself does the calculation. Banks will have full autonomy in order to determine the capital requirement concerning credits. They can determine the risk of the borrowers and therefore can influence the capital requirement by assigning favorable rating to their borrowers. This full autonomy can lead to the fact that through this approach the goals of Basel Committee will not be realized. Furthermore, data is the key element of this approach. In order to use this approach a lot of data is needed, which not all banks have in their database and even if they have the data, do they have the IT system in place to use such an approach? In emerging economies and also developing countries this will be the show stopper to implement this approach, because data is not available or not being published. IT challenges in these countries are also a major concern. 40

50 This approach also does not take all losses into consideration. As indicated it should also deal with expected losses. Beforehand it is not known what the losses will be; therefore the provisions can also not be determined. The moment a loan gets into default, provision is determined to cover the losses. This means that when the actual losses have been determined the real provision is determined which is not based on expectation. So, the expected losses should also be taken into account, because it is not an actual loss and provisioning is not yet determined for these losses. From analysis concerning the standardized approach in the previous section and the IRB approach in this section it is clearly noticeable that the IRB approach can mostly be used by banks established in developed countries. Developing countries will not be able to use the IRB approach. Several authors have indicated this. The reason behind this is that data is not available to implement the IRB approach. Furthermore, the standardized approach is controllable, because the risk weights have already been determined. Although the rating is being indicated by an external rating agency and can differ if there are several agencies, the outcome of this approach is more reliable than the IRB approach because rating is not influenced by the bank in order to decrease the capital requirement. Through both approaches favorable ratings can be assigned to borrowers, but in the case of IRB approach this will be greater than the standardized approach. Based on these analyses the standardized approach is the better approach to be used in order to determine the capital requirement for banking institutions. It fulfills the goals of Basel Committee. Every banking institution can use this approach especially the banks established in the developing countries, where the IRB approach cannot be implemented. Furthermore, no favorable position can be taken by banking institutions, because worldwide one specific approach is being used. Rating also is not controlled by the bank itself, but an external rating agency who determines the rating for a borrower. It is advisable that one rating agency is used in order to determine the rating for borrowers to eliminate discussions and confusions concerning several ratings assigned to a specific loan. Such a rating agency should also be managed and 41

51 supervised by the monetary authority of a country. This will lead to more reliability in the rating that is being assigned and the capital charges determined for a specific loan. 42

52 CHAPTER 4 RESEARCH DESIGN AND METHOLOGY 4.1 INTRODUCTION In this chapter the way the research has been conducted is presented. It provides the model, which is used in order to perform the analysis regarding the subject and research questions. As stated earlier this thesis is about the implementation of Basel II regulations for the banking sector in Suriname. Research framework, data collection, assumptions etc will all be dealt with in this chapter. 4.2 DATA GATHERING In order to collect data it is important to indicate that this research is an exploratory research. Based on the grounded theory (Pamela Baxter and Susan Jack, 2008) this research is conducted. The subject and the research question of this thesis indicate that this research is a qualitative research of which the result is not known before starting the analysis. Due to the fact that this research is a qualitative research the grounded theory is used, where data are collected through interviews and documents. Answers should be provided on questions based on how and why (Pamela Baxter and Susan Jack, 2008), e.g., The Basel II regulation leads to an increase in capital requirement; how did the capital requirement for the Surinamese banking sector increased? Another example is: the standardized approach leads to an increase in risk weighted assets; why did it lead to an increase and how did it occur? This research is an inductive study because a qualitative analysis will be performed. The outcome of this research cannot be applied everywhere in the world. It is an analysis done for a specific country, which in this case is Suriname, with its own economic environment, its own financial and banking system that differs from other countries, although the Basel II regulation has been developed to be applied internationally. To analyze whether the Surinamese banking sector does comply with the Basel II regulation concerning capital adequacy, the data have been collected through interviews and written materials. 43

53 Personal interviews have been held with key managers of several organizations based on a set of questions. These managers have been selected based on their responsibilities in their respective organization and other responsibilities in the society. The selected persons for the interview are: - CEO of De Surinaamsche Bank N.V. This is the largest bank and oldest bank of Suriname and the CEO of this bank is also the chairman of the banking union in Suriname. - CEO of Landbouwbank N.V. This is a small bank conform Surinamese standard and is also a stated-owned bank. - Key persons of the Central Bank of Suriname, who in their daily work are responsible for regulations, especially the Basel regulations These interviews have been held, based on a questionnaire (see appendix III). Based on these questions the researcher was able to determine what the New Accord means for the Surinamese banking sector concerning capital requirement, where we stand regarding Basel regulations in Suriname and what their criticism is regarding the Basel norms. The questionnaire was open ended, because it is important to know what people think of the regulations, which have been developed based on international development. To do a complete empirical study, based on what the objective is, written information is the most important data that have to be used for the analysis. The following documents have been used in order to reach the objective: - Monthly report presented by the Central Bank of Suriname, which is known as the Monetary Tables quarter 4 - Summary Balance sheet and Profit & Loss statement provided by the Central of Suriname - Other presentations of the Central Bank of Suriname that include Tier 1 capital, BIS 1 ratio, market share of commercial banks, loan versus deposit tables and non-performing loans. - Several annual reports of the Surinamese banks ( ) - Country report prepared by the International Monetary Funds (IMF) Based on these forms of data gathering the calculation will be performed for 2007, 2008 and The reasons for performing the analysis concerning these three years are: 44

54 - In Europe Basel I regulation was effective till 2007, which means that the implementation of Basel II started in In the United Stated of America implementation of Basel II was not agreed up till November 2007 (Atkinson, 2008). - In order to know if improvement or worsening is taking place concerning, for example, capital requirement or risk weighted assets, it is important to take into consideration a couple of years 4.3 METHODOLOGY This research is a qualitative research. As it is a qualitative approach, an own model has been developed in order to conduct this approach for providing solid answers on the research question that have been developed. Below this conceptual framework has been designed for this specific research. Research Question Conclusion & Recommendation Basel II Capital requirement Minimum Capital requirement Impact on capital / RWA Capital requirement for credit risk Findings and Analysis Standardized approach Internal rating based approach Documents Interviews Approach for the Suriname Banking sector Data gathering Analysis Suriname banking sector Figure 4.1: Conceptual framework 45

55 The above figure indicates how the research has been performed. First the research question is formulated (what has to be researched and what are the objectives). After this, the literature review is taken into account concerning Basel II; which are the approaches concerning capital requirement for credit risk and which approach is the best in order to analyze the capital requirement for an under-developed country as Suriname. Once this is done the analysis concerning the Surinamese banking sector is performed based on the research question and objective. In order to do the analysis for the banking sector of Suriname data is needed, which are collected through interviews and mostly documents. After this the findings are indicated and an analysis performed based on the why and the how questions. At the end the conclusion and recommendation are stated. As stated in the literature review, there are two approaches in order to determine the capital requirement regarding credit risk. In the case of Suriname only the standardized approach can be considered. Suriname is being classified as a developing country and in section 3.4 is already presented why the IRB approach cannot be used in order to determine the capital requirement for the banking sector of a developing country. Furthermore, it has been stated which approach is better to be used worldwide in order to determine the capital requirement for banking institutions. The internal rating based approach cannot be used in order to determine the capital charges, because a lot of data, to use this approach, is not available. One of the major concerns of this method is that not all banks have a rating system in place in order to rate borrowers and those who has a rating system; the question is if the system does comply with the requirement determined by the Basel Committee. Because the focus is on the capital adequacy of the Surinamese banking sector, the internal rating based approach cannot be applied. Through the standardized approach the capital requirement for the Surinamese banking sector will be determined in which most of the risk weights are based on the weights presented under the unrated category. The figure below presents the risk weights as determined by the Basel Committee for credit risk. 46

56 Credit Assessment AAA to AA- A+ to A- BBB+ to 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 20% 20% 20% 50% 150% 20% Credit Assessment AAA to AA- A+ to A- BBB+ to BB- Below BB- Un-rated Corporate 20% 50% 100% 150% 100% Credit Assessment Risk Weight (RWA) Retail 75% Loans secured by residential properties 35% 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 Non Performing Loan weight can be reduced to 50% with supervisory approval) Cash / Liquidity 0% Figure 4.2: Snapshot of the risk weights under Basel II concerning standardized approach Source: Constructed from Basel Committee on Banking Supervision, 2005 In order to calculate the BIS ratio conform Basel II, the first thing that has to be done is to determine which on-balance sheet items should be taken into consideration for assigning a risk weight under the standardized approach. Those balance sheet items with a risk weight of zero percentage will not be included. These zero weights can be assigned to the following on balance sheet items of the Suriname banking sector, namely cash, gold and credits with cash collateral. So these items will not be taking into consideration for determining the risk weighted assets. In order to determine the risk weights for the remaining balance sheet items some aspects of the research of Van Roy (2005) will be taken into consideration. In his research Van Roy used the Monte-Carlo simulation (which is a statistical approach) in order to determine if there is difference in capital requirement (if several external rating agencies is taken into consideration under the standardized approach). This research will not use the Monte-Carlo method, because the objective is not to verify if there are differences in capital requirement under several external rating agencies, but to identify if the Surinamese banking sector does comply with the Basel II regulation concerning capital requirement based on historical data of 2007 till The aspects that will be considered in this research and which are also taken into account by Van Roy (2005) are that in his research three scenarios were taken into consideration, namely: 47

57 - A combination of assets that is rated and others that are not rated (this is the real case scenario) - All assets are rated as indicated in Basel II (this is an extreme scenario indicated by Van Roy, but still analyzed this scenario due to the fact that assigning rating to borrowers is indicating a increasing trend) - Assets are rated, but capital arbitrage occurs. In order to calculate the capital charges for the Suriname banking sector, the first scenario of Van Roy (2005) will be taken into consideration, namely a combination of assets that are rated and others that are not rated. The reason why this is being indicated is because in the case of Suriname there is only one asset that is being rated, which are credits to sovereigns. International rating agencies assign rating to sovereigns. These rating agencies can be, for example, Standard & Poor s, Moody or Fitch. Since 2007 Suriname has been rated B+ (annual report De Surinaamsche Bank N.V., 2009) by Standard & Poor s, which means that loans granted to the government will get a risk weight of 100%. In order to determine the risk weight for banking institutions there are two options. Under option 1 the risk weight depends on the weight assigned to the sovereign. Option 2 is based on rating assigned by an external rating agency. Currently there are no institutions in Suriname that assign ratings to the commercial banks, therefore option 2 cannot be used. Another reason why this option cannot be considered is that data concerning short-term loans cannot be provided (short term loan < 3 months and long term loan > 3 months), therefore even the weights indicated under un-rated category of this option could not be taken into consideration. Because most of the claims on banks are on commercial banks of Suriname and because there are no credit ratings determined by supervisory authorities or other credit rating agencies, the risk weights under option 1 with no rating (un-rated) will be assigned to banking institutions. So a 100% risk weight will be used for claims on banking institutions. For corporate borrowers the un-rated risk weights will also be applied. The reasons why these risk weights will be used is, because of the following: 48

58 - In the current financial environment there are no rating agencies that can determine a rating to borrowers. - The commercial banks have their own system in place concerning rating credits that are being provided to borrowers. These rating systems differ from each other and are not reviewed by a separate institution. From interviews with different key persons in Suriname it can be determined that not all commercial banks in Suriname have a credit rating system in place. Based on these reasons the risk weight under the un-rated category will be considered, which in this case will be 100%. For the retail exposure and mortgages, the Basel Committee did not make a distinction based on rating, therefore the given risk weight of 75% for retail exposure and 35% of mortgages will be considered in calculating the capital requirement for the banking sector of Suriname. All other on-balance sheet assets of which no specific risk weight is presented in the Basel II regulations will be based on the risk weight indicated in Basel I. This is also mentioned in the New Accord. The other on-balance sheet items in the case of Suriname consist of fix assets and other assets. These items will be presented as other assets in calculating the solvency ratio to which a 100% risk weight will be assigned. For the off-balance sheet items a 100% risk weight will be linked to the assets, because no specific data could be obtained from the Central Bank of Suriname. The amount of the onbalance sheet item is derived for the annual report of those commercial banks that publish such reports. Due to the fact that no detailed information could be derived from the annual report in order to assign the right risk weight of 20% or 50% or 100%, the worst-case scenario is used and a risk weight of 100% is assigned. If the capital requirement is positive, which means that the solvency ratio is above the 8% for the Surinamese banking sector under Basel II, the real data concerning the off balance sheet item with the real risk weight will only lead to a stronger ratio. The last item, which is important to include in the risk weighted assets, is non-performing loans. This is a new asset type that is added in order to determine the capital requirement for credit risk, 49

59 although non-performing loans exist since credits are being provided. In Basel I no separate attention was given to this, but within Basel II it is taken into account separately. Again the Central Bank of Suriname could not provide detail data concerning non-performing loans. The only data, which was available, is the non-performing loan in relation to the total credit portfolio (the so called infection percentage). Further, as indicated in the literature review, the maximum amount a bank will lose in case a loan will get into default is the total amount outstanding the moment the loan gets into default. This is equal to 100%, therefore in this research a 100% risk weight is indicated to the non-performing portfolio. In the figure below a snapshot is indicated concerning the risk weight that will be used in order to calculate the risk-weighted assets for the Suriname Banking sector. Also is indicated the risk weight which is being used within Basel I for calculating the risk weighted assets. The reason for this is to show the difference between the 2 regulations developed by the Basel Committee and what is used in Suriname under Basel I. Table 4.1: Snapshot of risk weights for the Surinamese Banking sector under Basel I and Basel II On Balance sheet Basel I Basel II 1 Cash and other liquidity 0% 0% 2 Claims on government 0% 100% 3 Claims on banking institutions 20% (< 12 months) / 50% (> 12 months) 100% 4 Claims on Corporate 100% 100% 5 Retail Exposure (unsecured) 100% 75% 6 Retail exposure secured by mortgages on residential properties 50% 35% 7 Non Performing Loans N.A. 100% 8 Other assets 100% 100% Off Balance sheet Basel I Basel II 9 Guarantees 100% 100% 10 Letters of Credit 100% 100% Based on the risk weights indicated under the column Basel II, the calculation concerning the compliance with Basel II regulations will be performed for the Surinamese banking sector. The 50

60 calculation will be done for the years 2007, 2008 and The reason why the calculation will be performed for the mentioned three years is because implementation of Basel II in the world started in 2007 as indicated earlier. Furthermore, it can provide us information concerning the progress of the banking sector and capital requirement under this regulation, in case Basel II regulation would have been implemented by the Surinamese central bank in

61 CHAPTER 5 THE BASEL II REGULATION FOR THE 5.1 INTRODUCTION SURINAMESE BANKING SECTOR In this chapter the analysis will be done regarding Basel II regulation for the Surinamese banking sector. The focus will be on credit risk as described in the introduction and the literature review. Based on Basel II it will be analyzed if the banking sector of Suriname does comply with this new regulation regarding credit risk. Interviews will also be addressed in this chapter. Furthermore, capital as indicated by Basel Committee will be analyzed for the Surinamese banking sector. Analyses will be presented concerning credit, capital, risk-weighted assets, etc. 5.2 BASEL II CALCULATION As indicated, based on the data, which is available within the banking institutions and the data, which have been provided for this research, the only approach that can be taken into account for calculating the capital requirement for credit risk is the standardized approach. Performing the calculation for the Surinamese banking sector, based on the risk weights as stated in figure 4.3 of the previous chapter, the outcome is determined for the on balance sheet assets and off-balance sheet items. The data concerning the different types of asset have been gathered from documents provided by the Central Bank of Suriname and annual reports of several commercial banks (in appendix IV is indicated from where the data is gathered and in some cases how it is calculated in order to present the information in the tables below). The result for years 2007, 2008 and 2009 concerning the on-balance sheet items is indicated in table 5.1, while the off-balance sheet is presented in table 5.2. In the tables are illustrated only those balance sheet items, which are considered to be risky, conform Basel II. The risk weights as determined in the pervious chapter are shown per balance sheet item. Further, the tables provide data concerning the amount in SRD per items as it is being indicated on the balance sheet (e.g. claims on banking institutions is SRD 529,539,000). Based on these amounts and the risk weights it is being determined what the risk weighted assets (RWA) for that particular asset type are. So, for example, in the case of claims on banking institutions the RWA for this asset type in 2007 is SRD 529,539,000, which is equal 52

62 to the amount as presented on the aggregate balance sheet of commercial banks due to the fact that a risk weight of 100% is assigned to this exposure. Table 5.1: Risk weighted assets on balance sheet items (in SRD thousand) On Balance Sheet Risk Weight Exposure RWA Exposure RWA Exposure Assets (RWA) Claims on Banking Institutions Claims on government Retail exposure secured by mortgages on residential properties Corporate exposure Retail exposure unsecured NPL Other Assets Total On Balance Sheet Assets RWA % 529, , , , , , % 146, ,600 80,000 80,000 58,700 58,700 35% 256,987 89, , , , , % 968, ,383 1,283,310 1,283,310 1,455,390 1,455,390 75% 278, , , , , , % 94,270 94, , , , , % 337, , , , , ,975 2,611,716 2,375,134 3,010,543 2,672,838 3,597,841 3,221,102 Table 5.2: Risk weighted assets off balance sheet items (in SRD thousand) Off Balance Sheet Risk Weight Exposure RWA Exposure RWA Exposure RWA Assets (RW) Letter of Credit 100% 25,969 25,969 22,627 22,627 18,209 18,209 Guarantees 100% 57,368 57,368 61,404 61,404 68,622 68,622 Total Off Balance Sheet Assets 83,337 83,337 84,031 84,031 86,831 86,831 Based on the calculation in the above table the total risk weighted assets are determined by summing up the total risk weighted on-balance sheet assets and the total risk weighted offbalance sheet assets. The outcome of the total risk weighted assets for the Surinamese banking sector for the period is presented in table

63 Table 5.3: Total RWA of the Surinamese banking sector (in SRD thousand) Off Balance Sheet Assets RWA 2007 RWA 2008 RWA 2009 Total On Balance Sheet Assets 2,375,134 2,672,838 3,221,102 Total Off Balance Sheet Assets 83,337 84,031 86,831 Total Risk Weighted Assets 2,458,471 2,756,869 3,307,933 In order to calculate if the Surinamese banking sector complies with the Basel II regulation concerning capital requirement, the other main component is capital itself. As indicated the total regulatory capital for credit risk consists of Tier 1 and Tier 2 capital. Based on the data received from the Central Bank of Suriname, the total regulatory capital in SRD of the Surinamese Banking sector is presented in table 5.4. In order to calculate the BIS ratio under Basel II the same formula as determined under Basel I is used, which is: Capital Risk-weighted exposure from Credit risk > 8% (minimum ratio) In table 5.4 the BIS ratio under Basel II is shown for the Surinamese banking sector for the years 2007, 2008 and Table 5.4: Capital and RWA (in SRD thousand) and BIS ratio under Basel II during Capital 194, , ,182 Total Risk Weighted Assets 2,458,471 2,756,869 3,307,933 BIS Ratio 7.92% 8.56% 8.65% From table 5.4 it can be concluded that the Surinamese banking sector does comply with the Basel II regulation under the standardized approach concerning credit risk except for the year As already indicated, 2007 is the year in which globally the implementation of the Basel II regulation started. The reason why it is indicated that the Surinamese banking sector does comply with the Basel II regulation under the standardized approach is that the minimum 54

64 requirement of 8% is realized in 2008 and The 8%, which is the benchmark is also the norm, which is determined for the commercial banks in Suriname by the Central Bank of Suriname. There are countries in the world where the central bank of those countries deviates from the norm as indicated by the Basel Committee. An example of such a country is India where the norm for regulatory capital requirement is 9% (Raghavan, 2004). The Central Bank of Suriname has decided to maintain a level of 8% concerning the minimum capital requirement. 5.3 IMPLICATIONS OF BASEL II In order to do a proper analysis concerning the capital requirement it is important to verify this against the result calculated under the current regulation, which is Basel I. In chapter 2 it has already been shown that the Surinamese banking sector has sufficient capital under the Basel Accord in order to cover the risk associated with credit risk. Even the Tier 1 capital, which is indicated as being the core capital within Basel regulation, is above the 8% minimum capital requirement. Basically this indicates that the banks in Suriname have enough core capital to comply alone with the Basel I regulation. Table 5.5 illustrates the total risk weighted assets conform the risk weights under Basel I and the BIS ratio for the period The regulatory capital is the same as under Basel II, which in indicated in table 5.4. Table 5.5: Capital and RWA (in SRD thousand) and BIS ratio under Basel I during Capital 194, , ,182 Total Risk Weighted Assets 1,879,460 2,415,521 2,657,106 BIS Ratio 10.4% 9.8% 10.8% Source: Central Bank of Suriname Based on the BIS ratio indicated in table 5.4 and 5.5 the figure below is composed and it shows the progress of the ratio under Basel II versus the ratio calculated under Basel I by the Central Bank of Suriname since the period 2007 till

65 12.00% 10.00% Percentage 8.00% 6.00% 4.00% Solvency ratio (Basel II) Solvency ratio (Basel 1) Benchmark 2.00% 0.00% Year Figure 5.1: Comparison of BIS ratio under Basel I and Basel II during The figure above clearly indicates that the solvency ratio under Basel I is higher than the BIS ratio calculated under the standardized approach of Basel II. This implies that the standardized approach leads to an increase in capital requirement compared to Basel I for the Surinamese banking sector. More capital is needed in order to cover the risk the banking sector of Suriname encounters. Furthermore, in both cases (Basel Accord and New Accord) the BIS ratio is above the minimum requirement of 8%, as indicated by the Basel Committee, except for the year 2007 where under Basel II the minimum capital requirement was just below the norm. This statement indicates that the Surinamese banking sector is well capitalized under Basel II after 2007, which means that there is sufficient capital available in order to cover the credit risk. Another important analysis, which can be derived from the above figure, is that under Basel I the BIS ratio dropped in 2008 and then increased again in 2009, while under Basel II the BIS ratio increased continuously since This is tricky, because it can easily be stated that there is something wrong with the calculation of the BIS ratio under Basel II or it can be indicated that regulatory capital did not increase much under Basel I in 2008 compared to This statement is not correct, because under Basel II the same amount of bank capital is used to determine the 56

66 BIS ratio and the calculations, performed above concerning the ratio, are also correct. As already indicated, the Basel Committee did not change anything concerning determining the regulatory capital under Basel II. The same definition is used for the regulatory capital under Basel II as it is described in Basel I. The reason concerning why the BIS ratio under Basel II generally is below the BIS ratio under Basel I, why the BIS ratio under Basel II is below the minimum requirement in 2007 and why the BIS ratio under Basel II increased continuously compared to Basel I, which decreased in 2008, can be explained by the following figure. 3,500,000 3,000,000 Amount in SRD 2,500,000 2,000,000 1,500,000 1,000,000 Risk weighted assets (Basel II) Risk weighted assets (Basel 1) 500, Year Figure 5.2: Comparison of RWA under Basel II with Basel I during the period The above figure is composed based on data provided in table 5.4 and 5.5 concerning the total risk weighted assets. The figure indicates the movement of the risk-weighted assets under Basel II compared to the risk weighted assets under Basel I during the period 2007 till From figure 5.2 it can be derived that the risk-weighted assets under Basel II are higher than the risk weighted assets under Basel I in the indicated years. As stated in chapter 2, the Basel Committee did not change the definition of regulatory capital, which means that the way capital is calculated under the Basel I approach concerning credit risk will be the same under Basel II. Due to the fact that capital did change and risk weighted assets under Basel II increased compared to Basel I, the required capital to cover risks increased in the indicated years using the 57

67 standardized approach (which is being indicated as a revised version of the Basel I). The BIS ratio is determined by dividing regulatory capital (nominator) from the risk weighted assets (denominator). If the nominator is constant and the denominator increases, than the ratio will automatically drop, expressing an increase of risks, therefore more capital is required to cover the risk. This explains the first issue concerning the decrease in the BIS ratio under Basel II compared to Basel I. Several writers such as Van Roy (2005) have indicated that capital requirement under the standardized approach of Basel II will always increase compared to the Basel I regulations. The analysis for the Suriname banking sector confirms the analysis and results presented by several researchers like Van Roy (2005), which is an increase in the capital requirement. When the denominator increases, the capital requirement will increase. This means that the riskweighted assets concerning the commercial banks in Suriname have increased under Basel II. The reason why the risk weighted assets increased in Suriname is due to the fact that credits to banks and government are also being risk weighted, which is not the case in Basel I. Under Basel II both exposures (claims on government and banking institutions) have been risk weighted for 100% (see for detail chapter 4). These two exposures form a substantial part of the aggregate bank balance sheet of the commercial banks in Suriname. In order to show the effect of these two claims on the risk weighted assets, the table below is created (it is derived from table 5.4 and 5.5 presented earlier in this chapter). Table 5.6 indicates the contribution of the different type of assets to the total risk weighted assets of the banking sector in Suriname. 58

68 Table 5.6: Different type of assets in % of the total risk weighted assets in ( ) On Balance Sheet Assets Claims on Banking Institutions RWA 2007 RWA 2008 RWA % 13.98% 23.34% Claims on government Retail exposure secured by mortgages on residential properties Corporate exposure Retail exposure unsecured NPL Other Assets Total On Balance Sheet Assets 5.96% 2.90% 1.77% 3.66% 4.71% 4.61% 39.39% 46.55% 44.00% 8.49% 10.52% 8.46% 3.83% 4.31% 4.22% 13.74% 13.99% 10.97% 96.61% 96.95% 97.38% Total Off Balance Sheet Assets 3.39% 3.05% 2.62% Total Risk Weighted Assets % % % The above table indicates the share of each asset type in forming the total risk-weighted assets during the period 2007 till Although, under Basel II compared to Basel I, there is a decrease of 15% in the risk weighted assets for retail exposure secured by mortgages on residential properties and 25% decrease in risk weight on credits to unsecured retail exposure, the risk weighted assets still increased under Basel II. This is due to the fact that claims on banks and government are now being included in the RWA. In the case of Suriname the above table clearly shows that the contribution of credits to banking institution and governments together is around the 27% in 2007, 17% in 2008 and 25% in This roughly indicates that the RWA under Basel II has increased by the above percentage compared to Basel I, where the risk weighed assets for these asset types, namely claims on banks and government is 0%. Another interesting analysis is the contribution of retail exposure. The retail exposure consists of retail exposure secured by mortgages on residential properties and retail exposure unsecured. The contribution of these exposures together is around 12% in 2007, 15% in 2008 and 13% in 59

69 2009. This calculation indicates that the contribution of claims to banking institution are more than the retail exposure unsecured and secured through mortgages on residential properties in each given year. This could be due to the fact that there is an decrease in the risk weights of these types of exposure (retail exposure unsecured and secured through mortgages on residential properties), but the main point here is that the Surinamese banking sector indicates a higher claim on banks compared to retail customers and although the performance of most of the banks located in Suriname is better than the retail customers, the total amount of these institutions is counted to be risky taking into consideration the risk weight under the un-rated category. As indicated within Basel II banks should be rated by a rating agency. In Suriname banks are not being rated and because of this a high-risk weight has to be used. Although there is no external rating agency to rate banking institutions in Suriname, the 100% risk weight is still too stringent, because the Central Bank of Suriname has the data in order to determine the condition of a commercial bank of Suriname and how risky the claim on a specific bank could be. They are the regulators and are the institution, which is supervising and monitoring the commercial banks continuously. Therefore they know exactly the performance of the bank and can determine a rating. They are the best institution to indicate which part of the claim on banks can be considered risky and what risk weights can be used. This will obviously lead to a higher solvency ratio, which means a decrease in the capital requirement under the standardized approach. Furthermore, the recent financial crisis has questioned the functioning of an external credit agency. Each rating has a part of subjectivity. In order to determine a rating the criteria are based on objective indicators. In order to grant a rating to a borrower, not only the financial condition is important, but far more important is Know Your Customer which means other information besides the financials. The know your customer principle is much more important for a small country as Suriname. At present the Surinamese Bankers Association is busy with a research concerning a credit bureau. This bureau is not for granting ratings to borrowers, but is being established in order to keep records of borrowers. By establishing a credit bureau, cost can decrease and risk will be better managed, which can have a positive effect on capital requirement. Table 5.6 above also shows that the largest contribution to the risk weighted assets is being made by loans provided to corporate clients. This is the case each year which is analyzed in this 60

70 research. The contribution of corporate loans under Basel II does not differ with Basel I, because in both cases it is being assigned a risk weight of 100%, which means that the total credit amount is being seen as a 100% risky loan. So, for this exposure the capital requirement did not change for the Suriname banking sector. The 100% risk weight assigned to corporate loans in Suriname does not mean that the whole portfolio is risky. Due to the fact that there is no external rating agency, a risk weight of 100% had to be assigned. It is worth mentioning that all corporate loans in Suriname are provided based on collaterals. Most of the corporate clients in Suriname are sole proprietorship and limited liabilities. In most cases these clients provide their real estate (house, land, buildings, etc) as collateral. Other forms of collateral are also long-term deposits and cars (depending on the amount which the customer likes to borrow). Another fact is that the value of real estate in Suriname does not decrease. Even the recent financial crisis did not have an effect on the value of the properties, as was the case in the world. If a debtor gets into default and if it is determined by the bank in Suriname that the borrower will not be able to pay the debt back, the banks can immediately put up the real estate for auction, without court order. It is also worth mentioning that when a loan is provided in Suriname to a corporate client, first the market value of the collateral (e.g. real estate) is taken into account. Another value that is being determined for the real estate is the foreclosure value. This is the minimum value at which the real estate can be sold if the debtor gets into default and is unable to repay the debt. The foreclosure value is always below the market value. The third value, which is taken into consideration, is the collateral value. This value is always below the foreclosure value and indicates the maximum amount the borrower can borrow from the bank. So, based on this statement it is necessary that the country s environment is taken into account, and not just that a corporate loan has been granted and therefore a risk weight of 100% has to be used (because there is no external rating agency). Based on the above description a risk weight of 100% is high for corporate loans in Suriname. Furthermore, the foreclosure value is always higher than the collateral value and because most of the collaterals are real estate, banks in Suriname will, in most cases, be able to get their money back by selling the properties without going to court for a court order. Although there are no differences between Basel I and Basel II concerning corporate credits for the Surinamese banking sector, it is important to note that the corporate exposure and claims on banking institutions contributed the most to the total risk weighted assets under Basel II and this 61

71 leads to an increase in the RWA and a decrease in the BIS ratio illustrating that the capital requirement has increased compared to the current regulation. Furthermore, it is worth mentioning that the on-balance sheet assets contribute the most to the total risk weighted assets. In each indicated year the total risk weight on the on-balance sheet asset is more than 96%. This indicates that concerning guarantees, letter of credit, etc not much is being pursued and that there are almost no sophisticated products provided by the commercial banks of Suriname. As illustrated, when the denominator increases, which is for sure the case in Suriname under Basel II, the capital requirement will also increase under the condition that regulatory capital does not change or the change is smaller than the change in the risk weighted assets. This is important, because to provide an answer on the decrease in the BIS ratio under Basel II in the year 2007, a comparison has to be made concerning the increase in the risk-weighted assets from Basel I to Basel II. In table 5.7 is shown the percentage increase in the risk weighted assets under Basel I to Basel II. Table 5.7: Percentage increase in RWA under Basel II against Basel I in each year ( ) Increase in RWA under Basel II against Basel I 30.81% 14.13% 24.49% In the year 2007 the RWA increased with the highest percentage based on the standardized approach under Basel II compared to the other years. Table 5.7 shows that 2007 shows a huge increase of more than 30% in the RWA under Basel II. This huge increase in the RWA led to an increase in the capital requirement in 2007, meaning that the BIS ratio decreased. In order to provide a solid proof concerning the increase in capital requirement it is important to verify the percentage increase in capital from the year 2006 to Furthermore, it is important to indicate the % increase in RWA under Basel I in the indicated year. Based on data gathered concerning 2006 and 2007 the following is determined in table 5.8 regarding capital and RWA increase under Basel I. 62

72 Table 5.8: % increase in capital and RWA under Basel I % Increase Capital 151, , % RWA 1,319,461 1,879, % The above table indicates that the RWA under Basel I increased more than regulatory capital did. So, there was already a decrease in the BIS ratio in 2007 (the BIS ratio was 10.4%) compared to 2006 (the BIS ratio was 11.4%). Under Basel II the RWA increased by around 30% extra (see table 5.7). Capital did not increase under Basel II (the increase from 2006 to 2007 will not change once again if Basel II is applied). This leads to the huge decrease in the BIS ratio indicating that capital requirement will increase further. Due to the increase in RWA already under Basel I against capital and once again an increase in the RWA under Basel II, the BIS ratio decreased below the minimum capital requirement as indicated by Basel Committee and the Central Bank of Suriname. The huge increase in the RWA in 2007 under the Basel II regulation was caused by the introduction of RWA for claims in government and banking institutions. These two asset types contributed together around 27% to the total risk weighted assets in 2007 (see table 5.6), which is the highest compared to the other two years. Figure 5.1 also shows that the BIS ratio under Basel II has increased continuously since 2007, while Basel I indicated a drop in 2008 compared to Comparing the percentage increase of the RWA and capital under Basel I versus the New Accord explains the above noticed. Table 5.9 shows on the one hand the percentage increase in the RWA and capital under the Basel I Accord and on the other hand the percentage increase in the RWA and capital under the New Accord. Table 5.9: % increase in capital and RWA under Basel I and Basel II ( ) Basel I Capital 194, , ,182 RWA 1,879,460 2,415,521 2,657,106 % Change in capital % 21.31% % Change in RWA % 10.00% Basel II Capital 194, , ,182 RWA 2,458,471 2,756,869 3,307,933 % Change in capital % 21.31% % Change in RWA % 19.99% 63

73 Once again as can be seen in the table above, there is no change in regulatory capital between Basel I and Basel II. So the percentage increase concerning capital under both regulations is the same. The percentage increase implies the increase of capital or RWA of a given year compared to the previous year e.g. the percentage increase of capital in 2008 versus 2007 increased with 21.09% under both regulations. The above table indicates that under Basel I the increase in the RWA was higher than the increase in capital in The percentage increase concerning RWA is 28.52%, whereas the increase in capital is 21.09%. This led to a decrease in the BIS ratio in 2008 compared to 2007 under the Basel I Accord (see figure 5.1). The increase of capital against RWA is the other way around under Basel II in As calculated in table 5.9 the increase in capital is higher than the increase in RWA under the standardized approach of Basel II. Capital increased by 21.09%, while RWA increased just by 12.14%. This indicates that the BIS ratio in 2008 has increased under Basel II compared to the ratio in The huge decrease in the RWA under Basel II is due to the fact that the claims on banks decreased from around 22% in 2007 to around 14% in 2008 (see table 5.6), which indicated that more capital came free in order to cover other credit risk if it exists. Table 5.9 also indicated why the BIS ratio increased in 2009 under Basel I and the New Accord. Data in table indicates that under both regulations the percentage increase in capital is higher than the risk weighted assets. Therefore, there is an increase in the BIS ratio, which is also above the minimum capital requirement as indicated by the Central Bank of Suriname and which indicates than there is sufficient capital available to cover the credit risk. Table 5.9 leads to a third analysis. In a recent article (where we stand on bank capital, 2009) it is indicated that at 15 major banks in Europe the BIS ratio increased, due to the fact that RWA decreased. The most important finding was that RWA decreased but the assets of these banks did not decrease. Therefore there were questions concerning the risk-weighted assets. It was indicated that the decrease in the RWA was mainly realized through the introduction of Basel II and further it was stated that the decrease in the RWA (while assets did increased or did not change) led to the financial crisis. The government had to intervene to rescue the financial system by providing capital. This analysis makes it important to take this also into account for the Surinamese banking sector. That is why it is stated that table 5.9 leads to another analysis. 64

74 Table 5.10 presents the percentage increase of the total assets of the commercial banks in Suriname. Table 5.10: Total assets (in SRD thousand) and % increase in total assets ( ) Total assets 3,725,050 4,370,126 5,141,621 % Increase in assets % 17.65% Source: Central Bank of Suriname From table 5.10 it can be concluded that the total assets concerning the Suriname banking sector have increased continuously compared to previous years. The table indicates that in 2008 it increased by around 17% compared to 2007 and around 18% increase in 2009 compared to total assets in The important thing here to mention is that concerning the Surinamese banking sector there is an increase in total assets, but also an increase in RWA as indicated in table 5.9. None of the years indicates that there is a decrease in RWA while asset increased. The main reason behind this, compared to what happened in Europe, is that most asset items are based on a 100% risk weight, because ratings do not take place in Suriname. The decrease in the RWA in Europe is because of ratings that took place, which led to a favorable risk weight. These favorable risk weights led to a decrease in RWA, which led to an increase in BIS ratio indicating that there is sufficient capital available to cover the risk at the banks in Europe (capital requirement decreased). So, this analysis proves the concern of several researchers (as indicated in the chapter 3) regarding rating borrowers. From the analysis above it can be concluded that the Basel II regulations will have a negative impact on the capital requirement for the Surinamese banking sector. Although the banking sector realizes a BIS ratio above the minimum requirement of 8% under the Basel II regulation, the risk weighted assets increase, which means that more capital is needed to cover the risk. That is why it is indicated that the Basel II has a negative impact on the capital requirement. The table below gives a snapshot of the risk weights as indicated for the Surinamese banking sector in chapter 4 and what the impact of these risk weights is on the capital requirement. 65

75 Table 5.11: Snapshot of risk weights of the Surinamese banking sector and its impact on capital On Balance sheet Risk weight under Basel II Impact on capital requirement 1 Cash and other liquidity 0% No change 2 Claims on government 100% Increase 3 Claims on banking institutions 100% Increase 4 Claims on Corporate 100% No change 5 Retail Exposure (unsecured) 75% Decrease 6 Retail exposure secured by mortgages on 35% Decrease residential properties 7 Non Performing Loans 100% No change 8 Other assets 100% No change Off Balance sheet Basel II 9 Guarantees 100% Increase 10 Letters of Credit 100% Increase The above figure shows exactly the impact of the different assets items and its impact on the capital requirement for the Surinamese banking sector compared to the current regulation. As indicated in the above figure, there is an increase in risk-weighted assets due to claims on government and banks, whereas a decrease in risk weighted assets for the retail exposures occurs. The increase in the risk-weighted assets based on claims on government and banks is much higher than the decrease in the risk weighted assets based on retail exposure, indicating the capital requirement will increase. This means that the BIS ratio will decline compared to the current regulation. Furthermore, there is an increase in the risk weights of the off balance sheet items. As already indicated the reason behind this is that no detail information is given concerning these items, therefore it could not be indicated which risk weight should be used. In order to still do the calculation the total amount (100%) is indicated as being risky. 5.4 ANALYSES CONCERNING REGULATORY CAPITAL As presented in chapter 2 regulatory capital is divided into Tier 1 and Tier 2 capital. This is also important to analyze, because it is part of Basel II and influences the quality of the regulatory capital required to cover the risk. It is about the quality of the minimum capital requirement 66

76 against the risk the banking institutions are facing. In figure 5.3 is indicated the share of the Tier 1 and Tier 2 capital as components of regulatory capital. Figure 5.3: Tier 1 and Tier 2 capital in percentage of total regulatory capital ( ) Source: Central Bank of Suriname The above figure shows that the regulatory capital of the Suriname banking sector is made up for the large part of Tier 1 capital. This is the case in each indicated year. Furthermore, it can be derived form the figure that the Tier 1 capital is increasing continuously since 2007, whereas the Tier 2 capital decreases. Based on the components stated in chapter 2, the Tier 1 capital in Suriname consists of ordinary shares, retained earnings and disclosed reserve. Detail information concerning the components of Tier 1 could not be provided, but based on the available data per commercial bank in Suriname, which is indicated in table 5.12, it can be concluded that retained earnings contributed the most to the Tier 1 capital compared to the other components, namely common share and share premium, which is indicated as disclosed reserve by Basel II. Furthermore, it is worth mentioning that Suriname has a very small share market and once in two weeks shares are being trades. The share market of Suriname consists of eleven companies and only two of the large banks (De Surinaamsche Bank and Hakrinbank) are participating in the share market. Shareholders rarely sell their shares once it has been purchased. Also, rarely new shares are 67

77 being issued, so there will be no or very small amount of share premium being created. Table 5.12 indicates that there are no or hardly changes (% increase) in common share and share premium, while there are huge increases in retained earnings compared to previous years. Table 5.12: % increase in components of Tier 1 capital ( ) Common share / capital Share Premium Retained Earnings Banks DSB Bank ,396 66,783 80,074 RBTT N.A. N.A. N.A. N.A. N.A. N.A. N.A. N.A. N.A. HKB ,748 44,996 57,130 SPSB N.A. N.A. N.A. N.A. N.A. N.A. N.A. N.A. N.A. VCB N.A. N.A. 400N.A. N.A. LBB N.A. N.A. N.A. N.A. N.A. N.A. N.A. N.A. N.A. Fina bank ,383 4,971 6,975 SCB 4,500 4,500 4,500 1,073 2,101 3,503 Total 6, , , , , ,682 % Increase % % 24.26% Common share, retained earnings and disclosed reserve are being indicated as equity capital. Equity capital is also called core capital. In a recent article (where we stand on bank capital, 2009) it has been indicated that RWA decreased in Europe, which led to an increase in the BIS ratio. Although there was an increase in BIS ratio, banks still got into problems. Further research on 25 European banks indicated that capital increased also at these banks. Looking closely to the capital, it was noticeable that although Tier 1 capital increased, the core capital did not rise. Hybrid Tier 1 capital had a huge contribution to the increase in the BIS ratio in Europe. During the financial crisis this form of capital could not be used properly to absorb losses. In the UK for example, due to the financial crisis, a regulation has been introduced that banks must meet a core Tier 1 capital of 4%. Furthermore, a research done by Citibank (the bank capital adequacy, 2008) also indicated that the core capital of European banks did not increase, while Tier 1 capital rose. Taking this into account, in Suriname the Tier 1 capital of commercial banks is a solid capital, because it consists 100% of core capital as indicated by Basel Committee. It is quality capital and can be used fully to absorb losses. So, the minimum capital requirement under Basel II consists mainly of quality capital in Suriname. 68

78 In chapter 2 it is shown that under Basel I, even the Tier 1 capital is higher than the minimum capital requirement as indicated by the Central Bank of Suriname. Performing this analysis for the Surinamese banking sector under Basel II, the following figure is constructed. 9.00% 8.00% Percentage 7.00% 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% Year Tier 1 Benchmark Minimum Tier 1 Figure 5.4: Tier 1 capital/ RWA ( ) The figure above indicates that the Tier 1 capital divided by the RWA is below the norm of 8%, while in the case of Basel I (see chapter 2) is above this norm. The reason why under Basel II the Tier 1 is below the minimum requirement of 8% is because of the increase in RWA originated by claims on banks and government. The figure also indicates that the Tier 1 capital, which is fully core capital, has increased continuously since This is due to the fact that the % increase in capital is higher than the percentage increase in RWA compared to the previous year. In figure 5.4 is shown that the Tier 1 capital increased continuously in the indicated year. Thus the overall percentage increase in regulatory capital is because of the percentage increase in the core capital, namely Tier 1 capital. Finally, from the figure above it can also be derived that the Surinamese banking sector realizes a Tier 1 capital ratio above the minimum indicated by Basel Committee, which is 4%. Basel Committee has indicated that the minimum Tier 1 capital against the RWA should be 4% under Basel II (also under Basel I). In the case of Suriname, the banking sector is ahead by far of this percentage. Therefore, minimum capital requirement in Suriname is for sure quality capital. 69

79 The second component of the regulatory capital is Tier 2 capital. This type of capital also consists of different components as indicated in chapter 2, but the only component, which exists in Suriname, is the revaluation reserve. As stated there is a limitation concerning this capital, which is that, not more than 55% of the revaluation reserve should be part of the Tier 2 capital. In Suriname the Central Bank uses 40%. The reason why 40% is being used is because there are different methods in order to revaluate assets. Taking this into account it would be advisable to increase the revaluation value in Suriname from 40% to 55% as indicated by Basel. The reason why this is being stated is because the Central Bank of Suriname has already in place a regulation, which is about the revaluation of immovable. Furthermore, the Basel Committee has already a restriction on the revaluation reserve, which is 55%. This means that no matter what existing revaluation method is being used, banks should only include 55% of the amount. The Basel Committee has taken into consideration that there are different methods for revaluation and this could be the reason why the restriction of 55% is used. So, taking into consideration that the Basel Committee has already limited the amount concerning revaluation reserve and that the Central Bank of Suriname already has developed a regulation, further limiting the revaluation reserve is not necessary. If the 55% of revaluation is used for the calculation of the regulatory capital the following will happen concerning capital and solvency ratio (see table 5.13). Table 5.13: BIS ratio under 55% revaluation reserve in Tier 2 ( ) Total revaluation reserve % in Tier Total regulatory capital Solvency ratio 8.37% 9.01% 9.03% The table above indicates that when the 55% revaluation is taken into account, the total regulatory capital will increase. This will have a positive effect on the BIS ratio. It is worth mentioning that by taking the 55% revaluation reserve into consideration, the minimum capital requirement is being exceeded in 2007, which is not the case as presented earlier under Basel II. 70

80 CHAPTER 6 CONCLUSION AND RECOMMENDATION 6.1 CONCLUSION This research is about the new Basel regulation developed by the Basel Committee. This Committee was established in 1975 after the financial market was hit by a crisis in This new regulation is known as Basel II and is being seen as a revised version of the Basel I regulation. These regulations have been developed in order to create a level playing field between banks and to create financial stability and trust in the banking sector all over the world based on the factor risk and capital. In this thesis the research was about whether the Surinamese commercial banks fall short of Basel II capital requirement concerning credit risk. This research is important, because till now no study has been done in Suriname. Furthermore, several countries are moving towards Basel II, which is also the case in the Caribbean (Suriname is part of the Caribbean). Also the current financial crisis has emphasizes the importance of capital. The Basel II regulation is based on three pillars and under the first pillar is indicated the minimum capital required for different type of risk, among which capital requirement for credit risk. It is indicated that Basel II will have negative implications in less developed countries, such as decrease in loans to SME due to lack of information, increase in banking concentration because small banks are not able to meet the requirements, banks will move from risk sensitive credits to risk free credits (such as move from private sector lending to government bonds), competitive advantage will increase due to the different approaches, so there will be no level playing field, loan portfolio concentration will increase also and finally a credit pro-cyclicality issue will be created. 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. 71

81 Under the standardized approach the assets are divided in different classes (such as sovereigns, banks, corporate, retail, non performing loans, cash, etc). The classes, sovereigns, banks and corporate contain several rating groups. The risk weights have been developed per rating group. A requirement for this approach is an external credit rating agency. If there is no rating taking place in a country, there are risk weights determined for un-rated assets. Several writers have expressed their comments concerning this approach. It is being indicated that this approach creates an incentive for banks to provide short-term loans rather than long term, because for short term loan less capital is needed. Furthermore, it is being indicated that the existence of un-rated assets has a better risk weight compared to some of the rated assets. In such cases organizations will move from rated to un-rated category. Another concern is that rating is being provided by an external rating agency. The concern is that favorable rating will be granted in order to decrease the capital requirement. The difference in risk weight for small and long term loan should exist because short term loans are paid off earlier than long term loan, so the risk at a short term loan is relatively lower than long term loan. Another criticism about this regulation is that risk weights of 150% are used. This is very stringent, because the maximum risk is equal to 100% of the portfolio. Furthermore, under the un-rated assets category, most risk weights of 100% are used. This does not mean that poor quality loans are being provided. There are, of course, good performing loans. Therefore, other data could be used to determine the risk weight under un-rated category. A last remark is that for retail a 75% risk weight is used. This is not realistic compared against the corporate loans. The retail loans are, in most cases, unsecured, while corporate loans are based on collaterals. Therefore the risk at retail loan is higher than at a corporate loan. The internal rating based approach is the other approach for calculating the capital requirement for credit risk. In this model banks will use their own internal models concerning measuring credit risk. This is the major difference between the internal rating based approach and standardized approach. Through this model banks only need to have capital for unexpected losses, because it is being indicated that the expected losses are already being covered through pricing and provisions. In order to determine capital under this approach the risk components PD, LGD, EAD and M are essential. This approach can again be distinguished in the Foundation 72

82 IRB approach and Advance IRB approach. The difference between these methods is that under the F-IRB banks will determine the PD by themselves, while the supervisor determines the other risk components. Under the A-IRB the banks determines all the indicators except M. It is being indicated that this approach is more flexible to measure risk. Researchers have indicated that this approach can significantly influence bank lending in a negative way. Others have stated that this method will lead to decrease in capital adequacy compared to the standardized approach. One said that the reason behind the decrease in capital adequacy is because it does not consider expected losses. Others show that favorable rating can be granted in order to decrease capital requirement. The biggest concern of this approach is how reliable the calculation will be, because banks will use their own system and models to measure their risk. At the other hand lots of data will be needed in order to give a proper indication concerning the risk. The IRB approach cannot be used in Suriname, because not all commercial banks have a rating system in place. Therefore, the data are not available to do the calculation concerning capital requirement for credit risk. Furthermore, this approach does not fulfill the goal of the Basel Committee, which is creating a level playing field. Also not every bank over the world has the data available to use the IRB approach. Therefore the only method that can be applied is the standardized approach (it can be applied to every bank and also fulfill the goal of Basel Committee). Performing the analysis for the Surinamese banking sector concerning the years 2007, 2008 and 2009 it is noticeable that this sector does comply to the Basel regulation although there is no external credit rating agency in Suriname. Under this approach, most the risk weights have been used which are presented under the un-rated category. The reason why a 3-year analysis has been indicated is because Basel II implementation started around Furthermore, by doing so, a better analysis can be performed concerning the capital requirement (did it increase or decrease). The analysis shows that the Surinamese banking sector does comply with the Basel II regulation concerning capital requirement under the standardized approach. Although the banking sector does comply with this New Accord, the capital requirement increased compared to the current regulation. The reason why this occurred is due to the fact that the risk weighted assets increased, 73

83 where as regulatory capital did not change. The reason behind this is that no changes have taken place in the new regulation compared to the Basel Accord concerning regulatory capital. The increase in the risk-weighted assets is mostly contributed by claims on banks and government to which a 100% risk weight have been assigned. Analysis shows that assets type claims on banks and corporate loans constitute to the largest part of total RWA, both with a risk weight of 100%. Although a weight of 100% is indicated, the banks still manage to exceed the minimum requirement of 8% and improve it continuously. The reason behind this is that the percentage increase in capital is higher than the percentage increase in the RWA. Therefore, the BIS ratio increased continuously under the Basel II regulation indicating that there is sufficient capital available to cover the credit risk. Another key point is that corporate loans alone constitute more than 40% in the total RWA. Most of the corporate loans provided in Suriname are based on collaterals, such as real estate. Before granting a loan the collateral value is calculated and it can be concluded that the banks in Suriname will, in most cases, be able to get their funds back if the borrower cannot pay it back. This is being indicated, because a risk weight of 100% is too stringent for the banking sector in Suriname. Banks can also put the collateral immediately to auction, without court permission. Another important thing to mention is that the value of real estate does not decrease in Suriname. Even the financial crisis did not affect the value of real estate in Suriname. Therefore the 100% risk weight is too stringent for countries like Suriname. 6.2 RECOMMENDATIONS The following recommendation is being made concerning capital requirement for credit risk under the Basel II norm: The Basel Committee has developed these regulations based on development in the G-10 countries of the world. Local authorities should take into account the developments in their respective countries and if they decide to implement the regulation, adjust the regulation where needed, otherwise it can have a negative influence on the banking sector of the country. This is being advised, because as indicated, in Suriname (although there is no external credit rating agency) corporate loans for example, can be linked to lower risk weight, due to the fact that there is enough collateral provided by the borrower. 74

84 As presented, external and internal rating agencies can influence the rating of borrowers in order to decrease the capital requirement. This can also be the case when it is decided to implement the New Accord. In order to have a reliable rating for borrowers, it is advisable that the Central Bank of Suriname, establishes a unit under their supervision for granting ratings to borrowers. As this will be a department of the Central Bank it will increase the reliability, because the aim of the Central Bank of Suriname is to create financial stability within Suriname. On the other hand, this will lead to a better BIS ratio, which means that the capital requirement will decrease. The Basel Committee has used risk weight of 150%. This is also too stringent, because it unnecessarily increases the pressure on capital requirement. The maximum amount, which can get into default, is 100%. So, the maximum amount that will be lost is also 100%, therefore, why is there a need to weight these assets more than 100%? It is advisable to the Committee to take a look at these risk weights and if possible reduce it to 100%. This is not being indicated to reduce to capital requirement, but because there is no logic to have higher capital charges while the lost is maximum 100%. In order to create a level playing field it is important not to have different choices, because different methods have their own pros and cons. Based on this, it will be very difficult to create a level playing field. Due to the different approaches a bank can choose the approach, which leads to a decrease in capital requirement and create competitive advantages. This will lead to an increase in banking concentration and further financial instability. The Basel Committee has indicated that an external rating agency is required for the standardized approach otherwise risk weights under un-rated category must be used. For banking institutions an external rating agency is not needed. This task can be performed by the central banks themselves because they have the data in order to determine the performance of the local banks. Therefore a 100% risk weight under the un-rate category is too high. Because in Suriname there are just nine commercial banks, this task can surely be performed by the Central Bank of Suriname. The Central Bank should also force all banks operating in Suriname to publish annual reports. This will increase the reliability concerning the rating granted. 75

85 In terms of increasing capital base of Commercial Banks it is advisable that the Central Bank of Suriname changes the 40% revaluation reserve (Tier 2) capital to 55% as indicated by the Basel Committee. This is suggested because Basel Committee already has limited the amount to be included in Tier 2 and because the Central Bank of Suriname has also regulation in place in order to determine the revaluation value. The increase in the regulatory capital will mean that a higher BIS ratio will be realized indicating that there is sufficient capital available to cover the credit risk. 6.3 FUTURE WORK It is worth mentioning that a research is needed concerning market risk in Suriname. There is no study done concerning this although this type of risk is already part of Basel I. Research concerning operational risk is also not performed. This is also an interesting subject to research within Suriname. As indicated, international regulations are important, but it should be adjusted to local environment and developments. Therefore, before doing any adjustment a research has to be done starting from the base. That s why market risk and operational risk have to be analyzed also. Another interesting study could be regarding the internal rating based approach. In such a study emphasize can be on, for example, where do the Surinamese banks stand in order to implement the internal rating based approach? Last but not least this study indicates that under the standardized approach the Suriname banking sector does comply with the capital requirement under Basel II without having an external rating agency. Therefore a study can be conducted concerning the development and implementation of an external credit rating agency in Suriname under supervision of the Central Bank of Suriname. 76

86 REFERENCE LIST Atkinson, P. (2008). The Basel capital adequacy framework should be reconsidered. Retrieved from Altman, E.I., & Sabato, G. (n.d.). Effects of the new Basel capital accord on the bank capital requirements and SME s. Journal of Finance Services Research, 28: 1/2/3, Bank capital adequacy. (2008). Retrieved from 11dc-8b fd2ac.html Banking Supervision and Regulation. (2009). Retrieved from Basel Committee on Banking Supervision. (1995). Planned supplement to the Capital Accord to incorporate Market Risk. Retrieved from Basel Committee on Banking Supervision. (2001). The New Basel Capital Accord. Bank of International Settlements. Retrieved from Basel Committee on Banking Supervision. (2005). An Explanatory Note on the Basel II IRB Risk Weights Functions. Retrieved from Basel Committee on Banking Supervision. (2006). International Convergence of Capital Measurement and Capital Standards. Retrieved from Baxter, P. & Jack, S. (2008). Qualitative case study methodology: study design and implementation for novice researcher. The qualitative report. Volume 13. Number 4 Benink, H. & Kaufman, G. (2008). Turmoil reveals the inadequacy of Basel II. 77

87 Chorafas, D.N. (2004). Economic Capital Allocation with Basel II: cost, benefit and implementation procedures. United Kindom: Elsevier. Cornford, A. (2005). The Global Implementation of Basel II: prospects and outstanding problems. Financial Markets Center Danielsson, J., Embrechts, P., Goodhart, C., Keating, C., Muennich, F., Renault, O., & Song Shin, H. (2001). An Academic Response to Basel II. Retrieved from Ferri, G., Liu, L., & Majnoni, G. (2005). The role of rating agency assessments in less developed countries: impact of the proposed Basel guidelines. The World Bank; University of Bari (Italy). Retrieved from /ferri_etal.pdf Financial Stability Institute. (2004). The implementation of the new capital adequacy framework in the Caribbean, Bank of International Settlements. Retrieved from Gitman, L. J. (2009). Principles of Managerial Finance. San Diego: State University. Goodhart, C., & Segoviano, M.(n.d.). Basel and Procyclicality: acomparison of the standardized and the IRB approaches to an improved credit risk method. Retrieved from Gottschalk, R. (2010). The Basel Capital Accords in Developing Countries: Challenges for Development Finance. England: Palgrave Macmillan. 78

88 Griffith-Jones, S., & Spratt, S. (n.d.). Will the proposed new Basel Capital Accord have a net negative effect on developing countries? Retrieved from Illing, M., & Paulin, G. (2004). The New Basel Capital Accord and the Cyclical Behavior of Bank Capital. Retrieved from Ito, T., & Sasaki, Y.N. (2002). Impacts of the Basel Capital Standard on Japanese Banks Behavior. Journal of the Japanese International Economics, 16, Jacobson, T., Linde, J., & Roszbach, K. (2005). Credit risk versus requirements under Basel II: are SME loans and retail credit really different? Jacobson, T., Linde, J., & Roszbach, K. (2005). Internal ratings systems, implied credit risk and the consistency of banks risk classification policies. Journal of Banking and Finance, 30, Kirstein, R. (2002). The new Basel Accord, internal ratings, and the incentives of banks. International Review of Law and Economics, 21 (2002) Maduro, J., & Fox, R. (2007). International Financial Management. United Kingdom: Thomas Learning. Matten, C. (2003). Managing Bank Capital: Capital Allocation and Performance Management. England: John Wiley & Sons Ltd. Montgomery, H. (2005). The effect of the Basel Accord on bank portfolios in Japan. Journal of the Japanese International Economics, 19,

89 Powell, A. (2006). Towards Basel III Emerging. Retrieved from Raghavan, R.S. (2004). Bank s capital structure & Basel II. Retrieved from Rough. C., & Lee, L. (2008). A rethink of capital requirements for Asian Banks. Retrieved from s/capitals_views/ttp_asiachina_1009_cg.pdf Segoviano. M.A., & Lowe, P. (2002). Internal ratings, the business cycle and the capital requirements: some evidence from an emerging market economy. Retrieved from Sen, S. (2005). Basel norms on capital adequacy, the banking sector and the impact on credit for SME s and the Poor in India. In R. Gottschalk, The Basel Capital Accords in Developing Countries: Challenges for Development Finance (pp ). England: Palgrave Macmillan. Terry, C. (2009). The new Basel Capital Accord: A major advance at a turbulent time.retrieved from Van Laere, E., Baesens, B., & Thibeault, A. (2007). Bank capital: A myth resolved. Vlerick Leuven Gent Working Paper Series 2007/35. Vlerick Leuven Gent Management School Van Rooy, P. (2005). Credit rating and the standardized approach to credit risk in Basel II. Retrieved from Zicchino, L. (2005). A model of bank capital, lending and the macro economy: Basel I versus Basel II. Retrieved from 80

90 Woudsma, D. (2009). Een Kapitale opgave? De rol van epistemic communities in de ontwikkeling van internationale bankregulering. Retrieved from 009/D-Woudsma/ma D._SWoudsma.pdf Other sources: Annual report 2006 of the Central Bank of Suriname Annual report 2007 of De Surinaamsche Bank N.V. Annual report 2008 of De Surinaamsche Bank N.V. Annual report 2009 of De Surinaamsche Bank N.V. Annual report 2007 of Hakrinbank N.V. Annual report 2008 of Hakrinbank N.V. Annual report 2009 of Hakrinbank N.V. Annual report 2007 of FinaBank N.V. Annual report 2008 of FinaBank N.V. Annual report 2009 of FinaBank N.V. Annual report 2007 of Surichange Bank N.V. Annual report 2008 of Surichange Bank N.V. Annual report 2009 of Surichange Bank N.V. Annual report 2006 of VCB Bank Annual report 2009 of Trinidad and Tobago (Financials) IMF Country Report No. 07/179 (2007) IMF Country Report No. 08/294 (2008) IMF Country Report No. 10/44 (2010) IMF report: Suriname towards stability and growth. (2009) Monetaire tabellen (Monetary Tables) of the Central Bank of Suriname 81

91 APPENDIX I BASEL II FRAMEWORK Source: Dennis Woudsma (2009) 82

92 APPENDIX II INTERNAL RATING BASED FORMULAS Formula for corporate, sovereign and bank exposure: Formula for SME: The above formulas are used with an adjustment in the formula concerning correlation Formula for retail exposure: Residential mortgage exposure 83

93 Qualifying revolving retail exposure Other retail exposure Expected losses: Meaning of symbols: R: Correlation EXP: Exposure PD: Probability of default K: Capital requirement LGD: Loss given default N: Normal distribution G: Inverse of normal distribution S: Sales EAD: Exposure at default Source: Basel Committee on Banking Supervision,

94 APPENDIX III INTERVIEW QUESTIONS To: From: Drs. Aniel Ghiadoobe Subject: Request for interview Dear Mr. / Mrs. Currently I am doing the MBA program of the FHR Lim a Po Institute for Social Studies with specialization in Corporate Strategy & Economic Policy. In order to finalize my study, a thesis should be written. My thesis subject concerns about the Basel II regulation, where I will research the impact of this regulation on the capital requirement for the Surinamese banking sector. The reason behind this research is the fact that, till now, no study has been done in Suriname concerning these regulations. Furthermore, countries are moving towards the implementation of Basel II. This is also the case in the Caribbean, of which Suriname is part. Another important reason is the current financial crisis. A lot of countries are suffering from major losses in regards to their financial sector and a lot of banking institutions went bankrupt, because these banks do not have enough capital in order to cover the losses. As you know the Basel regulations are regulations that concerns about capital, which is needed to cover risks. That is why I have chosen to do the analysis for the Surinamese banking sector. My analysis will be limited to credit risk only, because this is the leading risk in Suriname and also of lots of other banking institutions. In order do a proper research, data is needed. This data will be gathered through written documents produced by the commercial banks in Suriname / Central Bank of Suriname and also through interviews. Through this letter I request you for an interview, so that I can do a proper research. On the next sheet the interview questions are indicated, to give you an idea of the information needed for this research. Looking forward to a successful interview I thank you hereby in advance for your cooperation. Regards, Drs. Aniel Ghisaidoobe 85

95 Interview questions: 1. The G-10 countries of the world have developed the Basel regulations. How important are these regulations for Suriname and developing countries? 2. What is your opinion concerning the introduction of the New Accord (Basel II accord)? 3. What would the New Accord (Basel II) mean for the Surinamese banking sector? 4. Several approaches are developed within the Basel II regulation concerning credit risk. Standardized approach, which is based on external rating and Internal Rating Based approach (IRB), which is based on internal rating. Is there an external rating agency in Suriname? 5. IRB approach is another approach for credit risk. Do banks in Suriname indicate a rating to borrowers in Suriname? 6. Does banks in Suriname take into consideration unexpected losses in order to determine the capital requirement? 7. Will risk weighted assets decrease and therefore decrease the capital requirement if there is an external rating agency? What about based on the internal rating system? 86

96 APPENDIX IV DATA GATHERING CONCERNING THE DIFFERENT ASSETS ITEMS Claims on Banking Institutions and Claims on Government: Component Claims on banking Institution Claims on Government The figures concerning claims on banking institutions are gathered from the short balance sheet provided by Central Bank of Suriname, while the figures from claims on government is indicated in the monetaire tabellen (monetary tables) of the Central Bank of Suriname in appendix 7 balansen der algemene banken. Retail exposure secured by mortgages on residential properties: Component Retail exposure secured by mortgages on residential properties Data is determined based on figures provided in the monetaire tabellen (monetary tables) of the Central Bank of Suriname in appendix 9-1 ( bestemming kredietverlening en beleggingen der algemene banken ) and 9-2 ( bestemming van de vreemde valuta middelen van ingezetenen bij de algemene banken ). Furthermore, Non-Performing Loans has been taken into consideration, because this had to be subtracted. For then Non Performing loans separate risk weights has been determined by the Basel Committee. 87

97 Retail exposure unsecured: Component Retail exposure unsecured Figures are determined based on data provided in the montaire tabellen under appendix 10 ( vorm van de kredietverlening en beleggingen naar economische unit der algemene banken ) and from appendix 9-1 ( bestemming kredietverlening en beleggingen der algemene banken ) where is indicated the Retail exposure secured by mortgages on residential properties in SRD. This is subtracted from the amount calculated based on appendix 10. Furthermore, Non- Performing Loans has been taken into consideration, because this had to be subtracted. For then Non Performing loans separate risk weights has been determined by the Basel Committee. Corporate exposure: Component Corporate exposure The amount concerning corporate exposure is determined based on data provided in the monetaire tabellen under appendix 10 ( vorm van de kredietverlening en beleggingen naar economische unit der algemene banken ), appendix 9-1 ( bestemming kredietverlening en beleggingen der algemene banken ) and appendix 9-2 ( bestemming van de vreemde valuta middelen van ingezetenen bij de algemene banken ). Based on the last 2 mentioned appendixes the Retail exposure secured by mortgages on residential properties in SRD is determined. After this has been determined, through figures indicated in appendix 10, it can be determined which part of mortgages should be included in the corporate loans (this indicated loans that has been part of commercial real estate). Furthermore, because most of the credits in foreign currency are provided to corporate clients and no specific data could be provided concerning the corporate loans and retail loans, the researcher has for simplicity considered the total amount indicated in 88

98 appendix 9-2 to be corporate loans. Furthermore, Non-Performing Loans has been taken into consideration, because this had to be subtracted. For then Non Performing loans separate risk weights has been determined by the Basel Committee. Other Assets: Component Other Assets The amount for other assets has been gathered from the short balance sheet provided by the Central Bank of Suriname. Non-Performing Loan: From the Central Bank of Suriname the following percentage is gathered concerning Non- Performing Loans: NPL ratio Credit 2007 Retail exposure secured by mortgages on residential properties Corporate exposure In % of total credits 2008 In % of total credits 2009 In % of total credits % % % % % % Retail exposure % % % unsecured Total Credits % % % % NPL 5.90% 5.50% 5.80% Total NPL Based on the total credits and the % NPL the amount of NPL per year is calculated. This amount should be subtracted from the total credits per credit type (Retail exposure secured by mortgages 89

99 on residential properties, corporate exposure and retail exposure unsecured). Because no detail data could be provided concerning the non-performing loans the researcher has calculated first the share per credit type in relation to total credit. Based on this the non-performing loan amount is divided per credit type and then the amount is determined concerning healthy portfolio. In the below figure this is indicated. NPL per credit type Retail exposure secured by mortgages on residential properties Corporate exposure Retail exposure unsecured NPL in 2007 Healthy Loans in 2007 NPL in 2008 Healthy Loans in 2008 NPL in 2009 Healthy Loans in Off balance sheet items: The off balance sheet items are not being published by the Central Bank of Suriname. Base on the information provided by commercial banks in their annual reports the figures concerning these items have been determined. 90