Optimizing credit strategies to manage the impact of Basel III

Whilst there was general agreement on the need to reform the global financial system after the 2007 financial crisis, the impact of the revised regulations published in 2009 by the Basel Committee on Banking Supervision (BCBS) has been felt far and wide.

Jose Maria Roldan, Chairman of the Basel Committee Standards Implementation Group has called the new framework a ‘regulatory tsunami’. The challenge facing many financial services organizations is how they respond in a timely way to changes in regulation whilst at the same time meeting obligations to maintain and grow shareholder value and profitability.

Asian banks were not seriously impacted by the financial crisis, but they have learnt from it and have felt pressure to implement tighter regulatory measures, like Basel III, to prevent such an event happening again, in Asia or globally.

Basel III puts focus on the right type & availability of capital and many banks are taking a top-down approach to ensure compliance. However an alternative bottom-up approach can be used to drive competitive advantage and improve decision making in all areas yet at the same time ensure regulatory compliance.

Basel III - China and Hong Kong
For some time it was unclear whether or not China and Hong Kong would comply with the regulation, but following a report from the China Banking Regulatory Commission it was agreed that the new regulation will be implemented from 1 January 2013 and all Chinese commercial banks will have to satisfy the Basel III criteria by the end of 2018.

The Hong Kong Monetary Authority announced earlier this year that Basel III will also be implemented in Hong Kong from 1 January 2013.

China has committed to adopting the new requirements with the aim of strengthen the local banking system's resilience and competitiveness. Industry analysts think it will have a positive impact on Chinese banks, allowing them to obtain better quality credit.

Banks in Hong Kong however, will face a number of challenges including tighter restrictions on credit lending. As a result, risk rating and credit assessment will play an even more significant role for Hong Kong financial organizations in the future.

Basel III – the key elements
The key elements of Basel III are designed to improve banks' liquidity management and increasing the size and quality of the regulatory capital they hold. Basel III is actually an add-on to the previous version of the minimum capital requirement regulation (Basel II) which aimed at improving the banking sector's ability to absorb shocks arising from financial and economic stress, strengthening banks’ transparency and disclosures and improving risk management and governance practices.

Basel III tightens the previous requirements making it compulsory for banks to raise their core tier one capital ratios from 2% to 7% to ensure they will not need assistance from taxpayers should they run into financial distress in the future.

Industry analysts predict that China’s five largest banks will have the least difficulty complying with the new capital requirements as they are all well capitalized, whilst midsize and smaller Chinese banks will face increased pressure owing to their weaker capitalization.

To ensure capital adequacy, each bank should assess their current risk levels, and run stress tests to ensure they are in a good financial position, and able to sustain strong financial health during a failing economy.

Stress tests should be run for different time intervals with forward looking scenarios, allowing lenders to assess future losses and to plan for appropriate capital management actions. This type of analysis also allows profit and loss forecasting as it measures future performance of consumer credit portfolios under various economic scenarios, set against industry benchmarks.

Basel III – reaction and impact
The new regulation will have a major impact on the banking market, specifically on average profitability, capital, liquidity and overall economic growth.

Banks are reacting swiftly to these new regulations, considering ways they can offset the negative impact on their return on equity and profitability. Some important initiatives aimed at offsetting the negative impact of the regulations are known as ‘risk-weighted assets (RWA) optimization strategies’.

The main levers banks can use to respond to Basel III include:

• Strategic and organizational changes – e.g. migrating to a new business model or organizational structure that will allow them to reduce the overall capital requirement;
• Asset liability management (ALM) initiatives – for example, reducing the maturity transformation effect and enhancing the liquidity of their assets.
• Changes in the structure of their portfolio composition - for example increasing retail lending (which has lower capital consumption) and reducing corporate loans (that have relatively higher capital consumption);
• Optimization of credit and sales strategies (e.g. change in product mix or pricing and other terms and conditions) to reduce capital charges

An alternative approach to optimizing RWA
Most banks are taking a top-down approach to offset the negative impact on profitability, implementing strategic and organizational changes. However a bottom-up operational approach can also be very effective.

To do so, banks will have to focus on maximizing their risk-adjusted performance to make the best lending decisions, given their business and regulatory constraints. At the same time, they will need to ensure consistency between their credit strategies and their strategic objectives.

Lending decisions in the front office will have to be aligned to the bank’s overall value creation objective, using dynamic modeling.

China is growing rapidly in real estate, energy, automotive, pharmaceuticals and manufacturing industry. These industries rely heavily on loans from banks. With Basel III taking effect, banks will need to be more cautious when lending in order to comply with the higher capital ratio and manage the challenge of liquidity shortfall.

The banks will have to make the best lending decisions to avoid any bad debt. An effective credit strategy with the help of a credit bureau that consists of accurate business data may minimize a lender’s risk exposure.

In practice optimizing credit strategies means making the best decision, adjusting factors such as acceptance criteria, collateral, pricing, limit setting and loan amount.

However, multiple constraints can impact this maximization problem, such as risk appetite, volumes, market share or operational capacity. Hence, a well-designed decision optimization framework would help provide a roadmap to develop a credit strategy that is best aligned with business goals.

The first step is focused on analyzing data to identify client, risk, income and financial variables, as well as propensities and sensitivities (i.e. probability that a client will react positively to change in pricing or in terms and conditions).

The next step will be the definition of goals, such as risk-adjusted profitability and will also include estimates of correlations between different variables. Once the framework is defined an organization can apply it to specific portfolios, building and analyzing different scenarios and setting different constraints using dedicated simulation software tools.

In the final stage, powered by a decision engine, the optimized credit strategies, designed in the simulation and testing environment can be deployed to the bank’s decisioning process.

Business analytical models and tools can help organizations not only address compliance issues, but also transform those regulatory requirements into compelling competitive advantage.

The optimization framework is a powerful tool that can improve the efficiency and profitability of organizations not only in the area of credit strategies and decisions, but also across several other areas of their business like marketing and collections.