Impact of Basel II on South Korean Banks
Basel II, which will be implemented at the end of 2006, is structured around three pillars: Pillar 1 deals with minimum regulatory capital requirements; Pillar 2 with the supervisory review process; and Pillar 3 with fostering market discipline through enhanced disclosure by banks. Under Pillar 2, local regulators are given discretion over certain aspects of the new accord. However, the exact scope of this discretion has not yet been determined, and many issues need to be resolved before the domestic version of the accord is finalized in South Korea. As a result, the accord might be adopted later than the end of 2006 by some South Korean banks. Moreover, there is a risk that the rush to meet the technical requirements of the accord will distract the banks from establishing the human resources to effectively run their risk management systems.
Data insufficiency is a fundamental obstacle for South Korean banks in adopting the internal ratings-based approach (IRB) outlined in Pillar 1, whose core requirements involve the calculation of loss-given-default ratios (LGD) per credit type. For most South Korean banks, recoveries on loan losses have not been stated clearly or managed efficiently on their records. At the same time, it has not yet been decided whether grace periods for interest payments (30 days for retail loans and 14 days for corporate loans) should be counted when defining defaulted credits.
In view of such difficulties, the requirement of the new accord that banks verify the credibility of their data and the track records of their systems for at least two or three years will be a challenge for most South Korean banks. The obstacles that banks face in preparing for Pillar 1 have prevented stakeholders from discussing the requirements of Pillars 2 and 3 in as much detail.
Despite the issues that remain in implementing the new accord, most banks still aim to complete their preparations by the end of 2006. In measuring credit risk, most of the banks surveyed by Standard & Poor’s plan to adopt the IRB, with a few banks aiming to bypass the foundation IRB and move straight to the advanced approach. In measuring operational risk, all of the banks ultimately want to use the advanced measurement approach, but more than half plan to use the standardized approach as a transitional measure.
The adoption of Basel II is expected to motivate South Korea’s banks to restructure their balance sheets, although local regulatory discretion over some aspects of the accord is likely to prevent any rapid and substantial changes in the appearance or behavior of the banks. Most notably, banks originating ABS transactions are expected to lose some of their incentive to provide credit enhancement due to heavy capital charges on tranches that are not rated or carry non investment-grade ratings. Secondly, the new accord lowers capital charges on banks’ retail portfolios, which could intensify competition for mortgage financing in particular. The preference by banks for corporate obligors with relatively good credit quality or collateral is likely to remain unchanged, while risk-based pricing could increase pressure on financially weak corporations. Finally, unused credit lines to corporate clients will be subject to higher pricing or size reductions. The new accord recognizes only true sales of assets and increases capital charges on risks remaining after the disposal of nonperforming assets. This is likely to improve the transparency of South Korean banks’ asset quality, as their incentive to remove nonperforming assets from their balance sheets should decrease.
Basel II also provides an opportunity for South Korea’s banks to improve their risk-management systems and enhance their profitability. Inadequate risk management and mismatches between prices and risks were among the underlying causes of the repeated damage to the credit profile of the sector in the past several years. To take advantage of the new accord, structural changes will be required to deepen the understanding of risk management and increase its importance in the strategic planning of South Korean banks.
South Korean banks’ capital adequacy is inferior to that of their international peers, which has been one of the factors constraining their credit ratings. Although the average capital adequacy ratio of the banks would appear to drop by over 2.5 percentage points if Basel II were adopted in its current form, the banks should be able to resolve this issue by the time the accord is actually implemented. Efforts by the banks to mitigate the impact of the new accord on their capital ratios over the next two years, as well as the regulator’s ability to grant discretional relief of certain capital charges in the South Korean version of Basel II, should reduce the decline in their regulatory capital ratios. To support their regulatory capital adequacy, South Korean banks are considering options such as retaining net income, adjusting their asset portfolios, disposing of treasury stock, and offering new shares.
To meet the complex requirements of the new accord announced in July 2004, South Korean banks and the FSS are working to determine the specific contents of the local version of Basel II. Similar to the challenges faced by banks in other countries, many issues need to be resolved before finalizing the domestic version. The FSS appears poised to distribute the first draft of the new accord to stakeholders within the next few weeks, and aims to finalize the details through discussion by early next year at the latest. Until the specific contents of the new accord are finalized, it is difficult to predict when exactly the banks will adopt Basel II. Considering the heavy burden on the regulator in reviewing each bank’s system and data credibility, and the relatively large differences in the preparatory measures taken by individual banks, the new accord might be adopted later than the end of 2006 by some or all of the banks in Standard & Poor’s survey. In the rush to prepare for Pillar 1, and as a result of the difficulties involved in this process, stakeholders have not been able to focus on Pillar 2 or Pillar 3 to the same extent. Moreover, the preoccupation of the banks with meeting the technical requirements of the accord appears to have weakened their focus on building up the human resources to administer a complete and effective risk management system.
Despite these issues, most banks are still aiming to complete their preparations by the end of 2006. In measuring credit risk, most of the banks plan to adopt the IRB, and a few banks envisage using the advanced IRB (A-IRB) without the transitional use of the foundation IRB (F-IRB). In measuring operational risk, all the banks ultimately plan to use the advanced measurement approach, but more than half plan to use the standardized approach (SA) first.
Data insufficiency and numerous uncertainties surrounding the details of the South Korean version of Basel II will make it challenging for most banks to verify their data credibility and system track records for the two or three years before the adoption of the new accord.
The IRB requires banks to calculate LGD ratios for each credit type. However, for most South Korean banks, recoveries on individual loan losses have not been stated clearly on their records. Accordingly, most of the banks are now spending much of their energy enhancing the credibility of the data by examining past documents or interviewing the relevant loan officers. For example, in cases where a certain portion of credit losses to an obligor were collected, some banks have applied the collected amount to unsecured credits before collateralized credits in order to increase the ranking of their claims on the obligor’s assets. It is arguable whether such recovery ratios can be applied to LGD estimates on unsecured loans in the future. As another example, both the external ratings and the data to internally calculate the probability of default (PD) for special lending are insufficient, and banks are still waiting for the FSS to establish the criteria for this lending. Internal data on operational losses is also very limited, with many banks supplementing the loss data with external sources, including overseas data pools. The assumptions made by banks in converting external data into internal data are a key issue, as each bank’s operating environment and internal system for managing risks is different.
It has not yet been decided whether the grace period for interest payments (30 days for retail loans and 14 days for corporate loans) should be counted when determining the definition of a defaulted credit. If the grace period is not considered as part of the nonpayment period in defining a defaulted credit, a retail loan will be classified as a defaulted credit after four months of missed interest payments. Banks in other countries, however, might classify such a loan as a defaulted credit after only three months. If the grace period is counted, some banks will need to revise their systems. The FSS plans to establish a methodology that matches the credit ratings of South Korean credit rating agencies with those of international credit rating agencies. The results of this mapping methodology are likely to influence the banks’ decisions on whether to choose the IRB or the SA for certain types of credit risk.
The adoption of the new accord is expected to motivate South Korean banks to alter their balance sheet structures, although the FSS is likely to use its discretionary powers to avoid any rapid and substantial changes in the banks’ appearance or behavior.
The biggest impact is expected in the market for asset-backed securities, given that the new accord places heavy capital charges on tranches that are either not rated or have non-investment grade ratings. This is likely to result in public issuance gaining popularity over private issuance. Furthermore, structures that use subordinated tranches to enhance the ratings on senior tranches are likely to be discouraged to a certain degree, unless there is substantial interest among investors in lower-rated tranches. Banks originating ABS transactions will also lose some incentives to provide credit enhancements to these deals.
Basel II generally lowers capital charges for banks’ retail portfolios, which could intensify competition for mortgage financing. When a bank adopts a more advanced approach to calculating credit risk, the capital requirements for mortgage financing decline more dramatically, possibly because the bank is likely to have a low default history and also because of the very high recovery rate for mortgage financing. Therefore, banks have an incentive to increase their shares in the mortgage financing market.
The preference by South Korean banks for corporate obligors that either have relatively good credit quality or sound collateral is likely to remain unchanged. Risk-based pricing could heighten pressure on financially weak corporations, although the government might take measures to mitigate the impact on small and midsize enterprises (SMEs). Compared with the capital charges under Basel I, the new accord seems to have a mixed impact on overall capital requirements for corporate loans, depending on the composition of each bank’s loan portfolio. If a bank’s corporate loan portfolio is weighted towards large and midsize companies with relatively good credit profiles, the capital requirements of its corporate loans appear to decline. However, if it has a portfolio tilted to small corporations with uncertain or weak credit quality, it will see an increased capital burden. Nevertheless, if the regulator allows the banks to treat corporate obligors with revenues of less than Korean won1bn as retail obligors, the overall capital charge on corporate obligors is likely to decline slightly. As the new accord specifies capital charges for unused credit lines to corporate clients, these credit lines will be subject to higher pricing or downsizing. In the past, South Korean banks offered comprehensive credit lines to some corporate obligors, which allowed the obligors to choose any type of facility within their credit limit. However, the banks did not charge fees for the credit lines in some cases.
In terms of ROA, South Korean banks have recorded average profitability of around 0.5 per centfor the past few years. This is weaker than the earnings of many of their international peers, due mainly to inadequate pricing and poor risk management.
The adoption of the new accord provides an opportunity for the banks to improve their risk management systems and enhance their profitability. Banks will have more motivation to emphasize risk-based-pricing, which will either intensify the conflicts between loan officers and loan marketers or encourage loan marketers to adopt a more conservative mindset. As risk-based pricing progresses, it will become more important for banks to adopt a comprehensive system to measure clients’ contributions to profitability. Nevertheless, Standard & Poor’s has observed that gaps between banks with a strong ability to assess the credit quality of an obligor and those with relatively weak capabilities are not easily narrowed, even though every bank is aware that credit risk assessment is a fundamental source of competitive advantages.
Basel II should enhance the quality of the FSS’s supervisory system, to the extent that the regulator does not sacrifice the spirit of the new accord in an effort to reflect local factors in the domestic version. The regulator’s continuous updates of its supervisory system in recent years have enhanced the transparency of South Korean banks’ credit profiles. However, the burden on the regulator to keep up with market developments has been heavy, and it has sometimes failed to enforce the required measures until after significant problems have emerged, such as the recent crisis in the credit card sector.
The adoption of the new accord will help South Korea’s banks to better measure and control risks, assuming that structural changes are implemented to increase awareness of risk management and make it an important consideration in deciding the strategic direction of a bank. Credible systems to measure risk, as well as valid data, are the basic requirements for an effective risk management framework. Inadequate risk management has been a weakness of several domestic banks, possibly because their desire for growth overshadowed the fundamental necessity to identify the risks inherent in their businesses.
As the new accord recognizes only the true sales of assets and stipulates higher capital charges on residual risks from asset disposals, South Korean banks will have a lower incentive to remove nonperforming assets from their balance sheets. Accordingly, the transparency of their asset quality should improve slightly. The new accord aims to match provisions for credit losses with the amount of expected losses, while covering unexpected losses with capital. At the moment, the methodology to define or calculate expected loan losses under the new accord does not appear to be clear to domestic banks and the regulator. However, expected credit losses seem to be larger than credit loss provisions for most banks, which may imply a need to strengthen the framework for provisioning against credit losses.
South Korean banks have inferior capital adequacy compared with their international peers, which has been one of the factors constraining their credit ratings.
If the new Basel accord were adopted in its current form as of today, the capital adequacy ratio of the banks would appear to drop by over 2.5 percentage points on average, raising concerns for a few domestic banks with relatively weak capitalization. However, when the domestic version of the accord is actually implemented, several assumptions of the current framework are likely to be revised. Moreover, banks’ efforts to mitigate the impact of the new accord on their capital ratios within the next two years should reduce the decline in their regulatory capital ratios.
South Korean banks have been exchanging opinions with the FSS to assess the impact of the new accord on their regulatory capital adequacy. Banks with relatively good profitability plan to bolster their declining capitalization by retaining net income over the next few years. Other banks are considering a combination of options, including retaining an increased proportion of net income, adjusting their asset portfolios, selling assets such as treasury stocks, and conducting rights offerings of shares.