Thursday 26, July 2018 by Banker Middle East

The material impact of regulation


Are UAE banks ready to deal with sweeping regulatory change? Bhaskar Sahay, Director in Advisory Services at KPMG Lower Gulf, shares his expert opinion.

The past year saw increased maturity in the banking sector, with technological advances and regulatory changes emerging as governing trends. As technology disrupts the space further this year, and in the years to come, the focus on regulations become even more pronounced. International Financial Reporting Standard (IFRS) 9 has impacted banks across the world and changed the way they approach and view the impairment process. In the UAE, IFRS 9 came into effect on 1 January 2018.

While most banks have been able to meet the deadline for implementation, it will likely take a while before IFRS 9 becomes business as usual. The standard has brought about far-reaching changes in many areas such as financial reporting, risk management, capital management, regulatory reporting, data sourcing and collection, governance framework as well as IT systems. The standard has, in many ways, integrated the risk, finance and IT functions of banks. To fully adopt IFRS 9, banks would be required to make significant time and resource investments. Current IT systems need to change significantly to calculate and record changes requested by IFRS 9 in a cost-effective and scalable way.

Additionally, data sources and models need to be further enhanced. Adequate infrastructure and systems should be made available for data, such as recording collateral information, costs and recoveries used in loss given default (LGD) calculation. Models that have been implemented need to be validated and monitored continuously to ensure smooth transition now, and effectiveness in the future. The implementation of IFRS 9 will also have to be supported by a robust governance policy ideally led by a board of directors, a steering committee, a working group committee and a technical working group committee.

The Central Bank of the UAE (CBUAE), Basel Committee for Banking Supervision (BCBS), Global Public Policy Committee (GPPC) and other such bodies have all recommended minimum standards of governance. In the UAE, when we analyse the 2017 yearly results from the top five banks, the increase in provisions is substantial. IFRS 9 therefore brings with it the need to reconsider some business lines and adjust portfolio strategies. Provisions under IFRS 9 are point-in-time and are thus closely related to the economic cycle.

Consequently, banks are expected to reassess their lending to sectors that are sensitive to the economic cycle. Likewise, loans with longer duration and bullet payments are likely to come under increased pressure because of higher expected credit loss (ECL). Increased current provisions lead to decreased profitability. Furthermore, the implementation of Basel III, together with IFRS 9, will lead to an increase in cost of capital for banks as the capital adequacy ratio will increase to 16 per cent by 2019, with an additional capital conservation buffer.

This has implications for the pricing of products, deal origination, maturity and amortisation of products offered. Credit management practises will also be impacted in the future as banks will have to estimate forward-looking expected loss over the life of the financial facility and monitor for ongoing credit quality deterioration. Collection teams would have to start their work sooner, considering the 30 days past due (DPD) threshold for significant increase in credit risk (SICR). Such monitoring will lead to an increase in collection and recovery costs. The role of the business teams is likely to be more onerous with incentive structures tied to an appropriate risk-adjusted profitability metric, such as return on risk-weighted assets, return on risk-adjusted capital or economic value added.

The other set of reforms are changes to Basel III, which is essentially the response of the Basel Committee on Banking Supervision to the global financial crisis. Though expected to be implemented in January 2022, amendments were made to the reforms in December 2017. First released in June 2011, the Basel III reforms were primarily aimed at strengthening the capital base of banks. They introduced two new liquidity metrics: the liquidity coverage ratio and the net stable funding ratio. Since then, the Basel Committee has been busy drafting numerous new standards, including redefining requirements for credit, market and operational risks. These are expected to provide greater risk sensitivity when it comes to how banks are required to manage risk, especially credit risk. The new standards are expected to impact the risk-weighted assets (RWAs), and off-balance-sheet exposures weighted according to risk, for all banks.

RWAs are an estimate of risk that determines the minimum level of regulatory capital a bank must maintain to deal with unexpected losses. Most banks globally—and indeed all banks in the UAE—use the standardised approach (SA) to determine credit risk capital. Thus, supervisors set the risk weights that banks apply to their exposures to determine RWAs. Under the recently released Basel changes, it is expected that RWAs for retail customers and financial institutions exposures will rise, thereby requiring banks to hold more regulatory capital against those exposures.

The financial crisis also highlighted weaknesses in calculating capital requirements for operational risk, or the risk of loss due to inadequate or failed internal processes, people and systems, or from external events. The 2017 reforms were therefore designed to: simplify the framework by replacing the four current approaches with a single, standardised approach; make the framework more risk-sensitive by combining a refined measure of gross income with a bank’s own internal loss history over ten years and make it easier to compare RWAs from bank to bank by removing the options to use multiple approaches, or to use internal models.

The 2017 Basel III amendments to credit and operational risk are likely to be implemented locally in the UAE on 1 January 2022. They will probably have some impact on processes and regulatory capital values, due to the overall increase on RWAs. Overall, it is estimated that for banks in Europe, this will lower the capital adequacy ratio (CAR) by approximately 50-70 basis points, with a similar effect on UAE banks.

The methodology for calculating these values will also require adjustments to systems as well as the collection of additional data requirements. Despite these transformational changes, the banking sector is in a good space and should continue to gain strength during the year. In 2017 the top ten UAE banks’ total asset growth exceeded five per cent, outpacing the larger country economy, which grew at about two per cent. With an increased focus on digital transformation, stricter regulations and improved culture, the sector is expected to be further refined.