Ratio Analysis of ACI Limited (Bangladesh)

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  • 1. Basel -IIThe basis for credit risk management is the requirements of “Basel II”, the agreement bythe major central banks on how commercial banks should be regulated. Basel II is thesecond of the Basel Accords, which are recommendations on banking laws andregulations issued by the Basel Committee on Banking Supervision. The reason forregulation is that banks lend long term but their deposits are liquid and short term, andso they are exposed (as all firms are) to cash flow problems. In order to ensure thatbanks don‟t fail, and to ensure confidencee in them by depositors, they must holdcapital reserves to cover from possible default by their borrowers.The first Basel Accord (1988) focused on credit risk, but it soon became clear that itsapproach was too common. In 1996 the Basel committee allowed banks to choose fortheir own Valuation Risk models. However there were still issues in the way differentasset classes and borrowers were handled by Basel I and by 2001 a new accord (Basel II)was being developed.The purpose of Basel II, which was initially published in June 2004, is to create aninternational standard that banking regulators can use when creating regulations abouthow much capital banks need to put aside to guard against the types of financial andoperational risks banks face. 1
  • 2. Three PillarsBasel II is based on three pillars: Minimum capital requirements are the calculation of the minimum level of regulatory capital that a bank should hold. There are two approaches, standardized and internal rating based approaches. These approaches will enable the calculation of the risk weighted assets and a bank is required to hold 8% of its risk weighted assets as risk capital. Supervisory review process provides guidelines for supervisors to ensure that each bank has robust internal processes for risk management and that banks could have adequate capital to support all the risks in their business Outline of the New Basel Capital Accord Pillar I Minimum Pillar II Pillar III Market Supervisory Capital Review process Discipline Requirement Operational Credit Risk Market Risk Risk Internal Rating Event Risk Business Risk Standardised Standardised Inernal Models Based Approach Approach Approach Approach Foundation Advanced Advanced Basic Indicator Standardised Measurement Approach Approach Approach 2
  • 3. Market disciple to encourage market discipline by developing a set of disclosure requirements which will allow market participants to assess key pieces of information on the scope of application, capital, risk exposures, risk assessment processes, and hence the capital adequacy of the institution. Objective of Basel-IIThe Main objectives of Basel-II are  Ensuring that capital allocation is more risk sensitive;  Separating operational risk from credit risk, and quantifying both;  Attempting to align economic and regulatory capital more closely to reduce the scope for regulatory arbitrage. 3
  • 4. Recent chronological updatesSeptember 2005 updateOn September 30, 2005, the four US Federal banking agencies announced their revisedplans for the U.S. implementation of the Basel II accord. This delays implementation ofthe accord for US banks by 12 months.November 2005 updateOn November 15, 2005, the committee released a revised version of the Accord,incorporating changes to the calculations for market risk and the treatment of doubledefault effects. These changes had been flagged well in advance, as part of a paperreleased in July 2005.July 2006 updateOn July 4, 2006, the committee released a comprehensive version of the Accord,incorporating the June 2004 Basel II Framework, the elements of the 1988 Accord thatwere not revised during the Basel II process, the 1996 Amendment to the CapitalAccord to Incorporate Market Risks, and the November 2005 paper on Basel II:International Convergence of Capital Measurement and Capital Standards: A RevisedFramework. No new elements have been introduced in this compilation. This version isnow the current version.November 2007 updateOn November 1, 2007, the Office of the Comptroller of the Currency (U.S. Departmentof the Treasury) approved a final rule implementing the advanced approaches of theBasel II Capital Accord. This rule establishes regulatory and supervisory expectationsfor credit risk, through the Internal Ratings Based Approach (IRB), and operational risk,through the Advanced Measurement Approach (AMA). 4
  • 5. July 16, 2008 updateOn July 16, 2008 the federal banking and thrift agencies issued a final guidanceoutlining the supervisory review process for the banking institutions that areimplementing the new advanced capital adequacy framework (known as Basel II).January 16, 2009 updateFor public consultation, a series of proposals to enhance the Basel II framework wasannounced by the Basel Committee announced. It releases a consultative package thatincludes: the revisions to the Basel II market risk framework.July 8-9, 2009 updateA final package of measures to enhance the three pillars of the Basel II framework andto strengthen the 1996 rules governing trading book capital was issued by the newlyexpanded Basel Committee. These measures include the enhancements to the Basel IIframework, the revisions to the Basel II market-risk framework and the guidelines forcomputing capital for incremental risk in the trading book. Basel-II in BangladeshIn Bangladesh, Basel II Road Map has already been issued by Bangladesh Bank, thecentral bank of the country. Basel II was implemented from January 2009. Basel II isimplemented with the following specific approaches as an initial step with the parallelcalculations was started from January 2009:  Standardized Approach for calculating Risk Weighted Assets (RWA) against Credit Risk supported by External Credit Assessment Institutions (ECAIs)  Standardized Rule Based Approach against Market Risk and  Basic Indicator Approach for Operational Risk. 5
  • 6. Implementation of Basel II in Developed CountriesImplementation of Basel II in developed countries would impact the developingeconomies in the following ways: High Cost Lending and Reduced Lending to Developing EconomiesThe Basel II accord has provided two approaches towards credit risk management.Banks in advanced countries and multilateral lending institutions are expected toimplement Basel II and they are the major lenders to the developing economies. On theother hand, an IRB approach would be even more stringent and applies extraordinarilyheavy risk weights. The Vicious Circle of Curtailment of Credit to Developing CountriesThe lower ratings will reduce the availability of funds in the developing countries. Thereduced market access and high costs of funding will further impact the ratings of thesecountries leading to a vicious circle with each aspect feeding the other in a downwardspiral. Higher Interest Costs and Competitive advantage of corporate borrowersThe Higher Interest costs to the banks will ultimately translate into higher cost ofborrowing for the corporate skewing the playing field in favor of the developedcountries. Impact on Infrastructure developmentThe Basel II document impacts the Interest rate determination process and attributeshigher risk to project finance than corporate finance. All the developing economies havebeen suffering from the paucity of Infrastructure to sustain development and this hasthe potential of severely hampering the Infrastructure development process. Shorter Term to maturity of lending 6
  • 7. Basel II accords have a preference for short-term lending. This is because of the ease inexiting the investment in case the situation turns adverse. Also the interest rates onshort term will also tend to be lower further incentivizing such borrowings. This shallimpact both banks and ultimate borrowers in developing economies because of thechange in the interest rate term structure and the need for Asset and LiabilityManagement (ALM). Impact on capital flowsShort Term lending will further increase the volatility of capital flows withindeveloping countries. This was a major reason of the Asian financial crises. Therewould be a tendency to press the panic button at the smallest change in the situation,further deteriorating it, leading to crisis. In the highly integrated global economy oftoday this will lead to stronger world economic cycles. Impact on CompaniesThis would impact output levels in corporate and skew the capital structure in favor ofshort term borrowings and working capital finance. The Liquidity position and thecompanies‟ ability to globalize would be hampered by this difficulty in raising long-term capital. Impacts of Basel II Implementation in Developing Countries Improved Risk Management and Capital AdequacyIt will tighten the risk management process, improve capital adequacy and strengthenthe banking system. Curtailment of Credit to Infrastructure ProjectsThe norms require a higher weight age for project finance, curtailing credit to this verycrucial sector. The long-term impacts for this could be disastrous. Preference for Mortgage Credit to Consumer Credit 7
  • 8. Lower Risk Weights to Mortgage credit would accentuate bankers‟ preference towardsit vis-à-vis consumer credit. Basel II: Advantage Big BanksIt would be far easier for the larger banks to implement the norms, raising their qualityof risk management and capital adequacy. Consolidation in the banking IndustriesTo the greatest extent possible, all banking and other relevant financial activitiesconducted within a group containing an internationally active bank has to be capturedthrough consolidation. Problems in Implementation of Basel II in Developing CountriesThere are some problems in implementation of Basel-II in developing countries likeBangladesh. Some of those problems are:- Standardized Approach and External Credit Rating ProblemsOne of the two approaches prescribed for Credit Risk in Basel II is the standardizedapproach, which makes use of external credit ratings for attaching risk weights. One ofthe major problems is the availability of credit ratings in developing countries. WhileBangladesh has been fortunate in this respect with two Credit Rating agencies(CreditRating Information and Services Limited and Credit Rating Agency of BangladeshLtd.),many developing countries are not so equipped in this field. Difficulties in Implementation of IRB based Credit Risk Management Approach 8
  • 9. Various models have been proposed for the Internal Rating Based Credit RiskAssessment. A major problem is data availability. In Bangladesh, State-owned banks arestill in the process of computerization. The extent of historical data required toformulate and then convincingly test Indigenous IRB models is simply not available. Costs of Implementation: IT spending and Training CostsThe single largest cost of implementing Basel II is the IT costs. The required capitalexpenditure would be far higher than small banks could bear. There is an unavailabilityof trained manpower for risk management and audits. Multiple Supervisory bodies and dearth of skilled professionalsThe Basel II definition of a banking company is very broad and includes bankingsubsidiaries such as insurance companies. In many developing countries, there is nosingle regulator to govern the whole „bank‟ as per Basel II. In Bangladesh, SecuritiesExchange Commission, Bangladesh Bank, National Board of Revenue, Dhaka StockExchange and Ministry of Finance would regulate different aspects of Basel II. InBangladesh, Regulatory capital norms do not apply to Insurance companies. Theavailability of trained risk auditors is another problem. Ineffective Pillar 3Aside from the broader issue of the relevance of specific disclosures for marketparticipants, this Pillar is not a very useful discipline device in countries with smallprivate markets or few incentives for creditors to monitor banks .In addition, the Pillar 3might be inapplicable in those countries whose systems are dominated by foreignbanks. Unavailability of required risk data in easily accessible or comprehensive formatHistorical loss data is required to calculate the main IRB risk parameters; that data arefrequently incomplete/unavailable or prohibitively expensive to collect .Particularly for 9
  • 10. the development of rating systems parameters, individual banks may not have ameaningful loss dataset to enable them to build the required models and back-test theirperformance. ConclusionSince, there are many problems in implementation of Basel II in developing countriesbut Basel II is here to stay and the competitive forces will compel banks to follow this. Itis very important to select carefully “what form of the Basel II standard” should beapplied and “to what extent” to ensure the survival and growth for the developingcountries. Ultimately, the standard are for strengthening the banking systems globallyand this objective should not be lost. Bangladesh Bank is giving highest concentrationand best possible effort for the implementation of Basel II. We think the new accordwould provide a level playing field for banking organizations meeting in internationalcompetition. References www.wikipedia.com International Research Journal Of finance and Economics 10
  • 11. Bangladesh Bank presentationInternational Convergence of Capital Measurement and Capital Standards. - T.C. Johnson And A.J. McNeil 11