The Effect of Basel III on Philippine Banks: The Case of First Metro Investment Corporation

in partial fulfillment of the course requirements inPRCECON

Submitted to:Mr. Angelo Taningco

Submitted by:Christofer Tan

Submitted On:Dec. 6, 2014

I. Introduction

Background of Study

The Base Committee on Banking Supervision was established on 1974 and since then it has been formulating and recommending the best banking standards and practices. Generally, their fundamental principle is a bank should always have ample capital to cover the different risks they take. In 1988, they issued Basel I which is the first banking framework that is primarily concerned with credit risk however was then refined to account for market risk. In 2004, they released Basel II. This was to cover the financial innovations of the years passed and it incorporates operational risks to the framework. In effect, this refinement was simply done to modernize the framework as a whole.

Some of the fundamental assumptions of financial institutions has been proven to be false during the financial crisis of 2008. Thus, on December of 2010, they released yet another refinement to the framework, the so-called Basel III. This framework presents new rules which were much tighter and stricter than ever before. This was intended to solve the banking problems made apparent by the financial crisis and to minimize the probability of them happening again. Essentially, this aims to increase both the quality and required quantity of banks' capital and in turn making banks more capable to absorbing risks and reducing the possibility of future banking crises (ParconSantos, & Bernabe, Jr., 2012).

Basel III attempts to plug the loopholes present in Basel II by recommending steps to further strengthen the overall financial system. Basel III strengthens the three Basel II pillars, which are Minimum Capital Requirements, Supervisory Review Process, and Disclosure & Market Discipline, by proposing many new capital, leverage, and liquidity standards to improve regulation, supervision, and risk management of the banking sector.

Capital standards and new capital buffers will require banks to hold more capital and higher quality of capital than under Basel ll rules. The new leverage ratio introduces a non risk based bank measure to supplement the risk based minimum capital requirements. The new liquidity ratios ensure that adequate funding is maintained in case of crisis.

ln Basel II, The first Pillar focused on minimum capital requirements. in Basel III, these minimum capital requirements were enhanced and new liquidity requirements were introduced.

Enhanced minimum capital requirements are:

(1) Quality and level of capital - Higher Minimum Tier 1 Common Equity Requirement from 2% to 4.5%, Higher Minimum Tier 1 Requirement from 4% to 6%, Minimum Total Capital Ratio remains at 8%.

(2) New Capital Conservation Buffer This is used to absorb losses during period of nancial and economic stress. Banks will be required to hold a capital conservation buffer of 2.5%.

(3) Countercyclical Capital Buffer - A countercyclical buffer within a range of 0% to 2.5% of common equity or other fully loss absorbing capital will be implemented according to national circumstances.

ln effect, these increases in capital ratios, stricter rules on eligible capital, and higher capital requirements may push the cost of capital, which will necessitate close monitoring as well.

On the liquidity side, on the other hand, enhanced liquidity requirements are:

(1) Liquidity coverage ratio - This was set to ensure sufficient high quality liquid resources are available for 30 days survival in case of stress scenario.

(2) Net stable funding ratio - This was set to promote resiliency over longer term time horizons by creating additional incentives for banks to fund their activities with more stable sources of funding on an ongoing structural basis.

In effect, banks are challenged to improve and more frequently produce regulatory liquidity risk reports and merge their current risk and finance systems to meet the new Basel Ill Liquidity Risk ratio requirements.

Next, the second pillar in Basel III enhances the Supervisory Review Process for firm-wide risk management and capital planning. This enhancement ensures that banks have adequate capital to support all the risks in their business. Also, these encourage banks to develop and use better risk management techniques in monitoring and managing these risks such as managing risk concentration. There will also be incentives for banks to better manage risk and return in the long run through sound compensation and valuation practices. Trading books will be subject to stressed value at risk requirement. Lastly, such supervisory review will enable early intervention of supervisors if banks capital doesnt not sufficiently buffers risk inherent in their business actives. Hence, all in all, the second pillar basically intends to ensure that banks have enough capital to support the various risks they take.

And lastly, the third pillar in Basel III enhances the Risk Disclosure and market discipline of banks. These enhancements include the revision of disclosure requirements. Also, it enhances disclosure on detail components of regulatory capital and their reconciliation to reported accounts, as well as requiring a comprehensive explanation of how a bank calculates its regulatory capital ratios. All in all, the third pillar, essentially, is a discipline followed by banks that complements the first 2 pillars (BIS, 2011).

On January of 2014, the Philippines adopted this new banking system. It is said by the Banko Sentral ng Pilipinas that this was primarily done in order to strengthen bank capital to better absorb losses and introduce a new global standard on liquidity risk management. One of the changes made on the minimum capital requirement is that the capital adequacy ratio requirement or CAR is increased to 10%. Additionally, the new framework increases the minimum CET1 ratio to 6% and the Teir 1 Capital Ratio to 7.5%.

Not only are we adopting this banking system rather early but we are also upping the benchmarks, as most of these standards are higher than that of the international Basel III norm. For example, the international minimum for CAR is only 8%. This is done to impose a safer banking system in the country thus making banks less prone to financial failures. Also, the international standard timeline of the BCBS gives banks until 2019 before fully implementing this framework in order to give banks ample time to generate capital. However, since the Philippines was doing better compared to neighboring countries, BSP decided that an earlier adoption date is best (Banko Sentral ng Pilipinas, 2013).

CAR stands for Capital Adequacy Ratio; this is the ratio of a banks capital over its risk weighted assets. This measures the banks ability to absorb its risks or in simpler words, its the capital cushion of the banks against potential losses. Generally, the higher the ratio, the more capable the bank is to absorb its risks. The formula of CAR is as follows:

Where Tier 1 Capital is the minimum capital needed for the bank to absorb its losses without forcing the bank to halt its trading activities. While Tier 2 Capital, on the other hand, is the capital that can absorb losses in the event of a winding-up and so provides a lesser degree of protection to depositors.

Thus, with that all said, to meet this tightened standard, banks must adjust their books thoroughly and for most banks this is not an easy task, especially with the limited time given.

Statement of Problem

Hence, the main problem that this paper aims to answer is how do bank adopt to this newly imposed banking standard?

Objective of study

The primary objective of this paper is to find out how can banks effectively abide by the newly imposed banking standards of the Philippines while retaining their profitability and stability.

Scope and Limitation

This paper is limited to First Metro Investment Corporation as this is a case study of this company. First Metro was incorporated on 1972 and started its operations as an investment house with quasi-banking functions in 1974. Fast-forward to today, it has become one of the, if not the, best investment house in the country with Investment Banking & Strategic Finance, Treasury, and Investment Advisory as its main functions. Also, this study will only be limited to the micro-economic level and will not cover the macro-economic effects of the Basel III.

II. MethodologyAs stated in the previous paragraphs, the objective of this study is to see how banks can effectively follow the guidelines set by the Basel III. In order to achieve this, we take a look at the case of First Metro Investment Corporation and how they have effectively transitioned from the pre-Basel III era to today. We look at the different techniques and methods they have used in order to abide by the new framework while maintaining profitability and stability of the company. We also examine how they changed their entire business model in order to cope with sudden and drastic change.

More precisely, we examine how they managed to adhere to new CAR constraints. As mentioned earlier, CAR is a function of the banks capital and its risk-adjusted assets. Hence, the bank will either adjust the numerator which is the capital or the denominator which is the risk adjusted assets. From capital re-allocation to different risk management schemes, this paper will take a deeper look the various approaches the company took to adjust the said parameters.

Looking at First Metro, they have basically use two main approaches in order to abide by this new set of standards. First is by Divestment, which is essence just the opposite of investing. More correctly, according to Kengelbach et al. (2014), divestment, also known as divesture, is simply the reduction of some kind of asset to achieve another personal or corporate objective. Thus, fundamentally, FMIC just divested their resources and used them for other investments instead. This in turn helps increase their CAR, by lowering the denominator, to meet the new minimum.

The other approach is by changing their central business model. While the first approach focuses on meeting the new requirements set by the central bank, this next approach focuses on maintaining their profitability. For most of the previous years, FMIC, being an investment house, has been focused on investing. However due to the new constraints, it is becoming more and more difficult for them to maintain their current income while minimizing investments. Thus, they have shifted their model to have less investements and offer more financial services such us undermining. In this case, bulk of their income now comes from fees from the services they provide instead of the assets they own.

III. Data and Analysis

As stated in the introduction, one of the main requirements to be met by the bank is the minimum CAR which also happens to be one of the most challenging to meet. Again, CAR is basically the capital on hand of the institution over its risk weighted assets. Hence, in order to increase this, one has to either increase the capital or minimize the assets.

First, we take a look at what they have done with the numerator, which is their capital. At first glance at their statement of financial position, it can immediately seen that they have increased their total equity to almost P19 billion in 2013 from the P14 billion the previous year. In comparison, they only grew P3 billion from 2011 to 2012. Taking a closer look, it can be seen that the bulk of this increase can be attributed to the increase in Retained Earnings, which increased by almost P4 billion from P9 billion the previous year to P13 billion in 2013. Also, retained earnings is considered a tier 1 capital.

Additionally, to comply with the more rigorous capital requirements the company unloaded its held-to-maturity investments, or simply HTM investments, as one of its capital raising strategies, as approved by the board of directors on February 2013. Immediately after the approval, the company reclassified its entire HTM investments with principal value of P16.3 billion to available-for-sale investments, or simply AFS investments, since the company no longer intends to hold these securities up to their maturity but is ready to sell them as soon as possible given it is sold at a value that would favor the company. Out of the all the HTM investments reclassified to AFS investments, P11.0 billion was already sold by FMIC which generated P4.0 billion gain which is under Trading and securities gain.

Next we look at what they have done with the denominator, which is the risk weighed assets. Again, by looking at their statement of financial position, we can see that they have decreased their total assets from P87 billion the previous year to P82 billion in 2013. This can be largely be attributed to the divestment the company has been doing all through out the year. Looking at their income statement, it can be seen that their income from sales of assets is up almost 7 billion from a minuscule P28 million in 2012 to a very high P7.5 billion the following year. Thus, by the end of 2013 the companys CAR was at a healthy 23.13% under Basel III which is well above the minimum ratio.

Aside from the capital adjustments, with the enhancements in the supervisory review process for firm-wide risk management and capital planning, the company is forced to lessen the risks the company takes. This is evident as their maximum exposure to credit risk decreased from P10 billion in 2012 to just P7 billion in 2013. Hence, less risk equals less reward which means that this diminishes the companys ability to earn more.

With that all said, we take a look at how the fundamental business model of the company has changed in order to accommodate these new requirements of the central bank. So to maintain its profits given the decrease in assets and risks taken, the company shifted its focus from assets to services. And instead on relying on their assets for their main source of income, they now heavily rely on service fees and what not as their primary source of income. Looking at the income statement, it can be observed that, setting aside the P7 billion from gains on sale of assets which obviously ballooned due to the divestments discussed earlier, bulk of the companys income now come from either Trading and securities gain or Service charges, fees and commissions which is not the case from the years gone by. As the trading and securities gain of 2013 alone has already surpassed the total income earned the previous year.

IV. Conclusion

Basel III, with its stingy regulations and benchmarks, has proven to be a very difficult standard to abide by. However, as seen and proven by this case study, it is still possible to maintain profitability and keep the money flowing while also following the new rules set by the central bank.

Thus the problem of whether a bank can follow these newly imposed rules while maintaining its stability has been addressed. With the proper reallocation of the companies assets and equity, whether it be divesting your current assets or reclassifying your securities, it is indeed possible to meet their requirements. However, this is not without consequence, as this usually disrupts the companys stability due to its negative effect on income. On top of that, banks are forced to carry less risk in order to ensure banks stability hence their income takes another hit. Therefore, banks must find new alternate methods in order to recover what was lost and in the case of First Metro, a change in their business model was the answer to the problem.

In the end, I would recommend further studies with regard to this new regulations and how it affects banks as this case study has a very very small sample size of one. Also I would recommend looking at how the Basel III affects the macro-economic factors such as lending rate and loan growth as these were not tackled in this paper.

Reference:

Bank for International Settlements. (2011). International regulatory framework for banks (Basel III). Available via the internet: http://www.bis.org/bcbs/basel3.htm

Banko Sentral ng Pilipinas. (2013). Banko Sentral ng Pilipas Memorandun M-2013-008: Frequently Asked Questions on Basel III Implementation Guidelines. Retrieved from: http://www.bsp.gov.ph/downloads/regulations/attachments/2013/m008.pdf.

First Metro Investment Corporation. (2014). 2013 First Metro Annual Report. Retrieved from http://www.firstmetro.com.ph/assets/annualreports/2013%20First%20Metro%20Annual%20Report.pdf

Kengelbach, J., Roos, A., & Keienburg, G. (2014, October ). Creating Shareholder Value with Divestitures. Retrieved December 1, 2014, from https://www.transactionadvisors.com/insights/creating-shareholder-value-divestitures

ParconSantos, H. C., & Bernabe, Jr., E. M. (2012). The Macroeconomic Effects of Basel III Implementation in the Philippines: A Preliminary Assessment .BSP Working Paper Series,2012-02, 1-23.

A. From day one I have been tasked with a ton of reading materials, ranging from the financial ratios to the different types of risks that banks are involved in. Thus, it has truly been a learning experience for me, at least from a educational stand point. Moving on, I was able to attend several meetings with regard to risk management and was able to see the tools they use to calculate the risk they take which has been insightful. Likewise, it has been a privilege to be able to attend several Bloomberg seminars which was equally as insightful. With that all said, I still believe that the most important thing I learned the past few months is what real work feels like, what nine-to-five, five days a week feels like. I think that more than all the knowledge you get from the training, still its the experience that most crucial. Its understanding how the corporate world works. Its realizing the difference between the office and the classroom, its the understanding the difference between your boss and your professor. In the end, after through it all, I can say that experience is indeed the best teacher.

B. First and foremost, I believe that the 200-hour requirement is too short for a student to be truly versed with the work environment. I believe in order for a student to have a better grasp of what working feels like, the school must require longer hours. Also, 200 hours is too short for a student to be trained well by the company. Usually companies like to rotate their interns for them to be better exposed to the different departments of the company. However, with only 200 hours, this is hard to do. Another suggestion is to maintain the 200 hour requirement but now require students to work for 2 different companies, this way, he or she can be more exposed to the different working environments. Even better if the student is able to work for 2 companies from different industries, not only will be exposed to different environments, this will also help the student know what career path he or she should take.