--By Sujit Mundul

History shows that it was never easy for regulators in any country to determine as to how much capital was needed to strengthen the financial foundations enough to support economic growth in the face of varying challenges. It became more difficult as financial innovations spread, leading to the 1988 adoption of model rules by a group of central banks and regulators that was based in Basel, Switzerland. That accord, later called Basel I, did set up risk weightings for various types of assets.

With the passage of time, as the inadequacies of such a fixed system became clear, the regulators perforce had to move to one that allowed more fine-tuning, called Basel II. This system allowed banks to use their own models – or credit ratings from Moody’s, Fitch and Standard and Poor’s – to determine how risky an asset was, and therefore how much capital was needed.

However, Thomas Hoenig, the then Vice Chairman of the Federal Deposit Insurance Corporation (FDIC), made the following comments, a week after the FDIC voted to propose the new rules along with other regulators:

“Risk weighting is based on a very arcane, very complicated series of ratios and formulas that are immediately gamed, and makes systems more fragile.” He also said that the average risk weighting of bank assets fell, year after year, as the banks got better in complying with the regulations.

The risk weighted assets form the basis of the capital figures of the banks from time to time. If a bank has 6.5% capital, it means capital equals 6.5% of the asset after risk-weight adjustments. Until the not-to-distant past, government bonds from European countries were “Zero” weighted meaning virtually risk free. Collateralised debt obligations, many of which turned out to be high risk, carried only a 7% weighting.

The result was devastating in that banks tended to load on the highest yielding assets with a given risk weighting. Since many mortgage securities had AAA ratings that led quite a few European and US banks and financial institutions to lose a lot of money when the sub-prime mortgage market in the US collapsed in 2008.

Post global financial crisis, the BASEL committee on Banking Supervision (BCBS) released a comprehensive reform package in Dec 2010, entitled, “Basel III”. The main objective of Basel III was to improve the banking sector’s ability to absorb shocks arising from financial and economic stress, whatever be the source, thus reducing the risk of a spillover from the financial sector to the real economy.

We are aware that the financial crisis led to wide-spread bail outs, but the details differed in ways that may have been critical. European banks didn’t show much interest to sell shares to investors in 2010 when markets opened up. But in the United States, banks having received a bail-out became, as Jamic Dimon put it, “A Scarlet Letter.” To repay the bailout, and avoid the stigma, banks preferred to sell new shares. The unpopularity of the bailout helped the banks.

Now let us look at the emerging market banks. The contagion effect of the Global Financial Crisis in 2008, had also affected the emerging economies albeit a little later and the smaller countries were no exceptions. The major reason behind this was the gradual globalisation. However the Asian countries were less affected, as the Asian Central Banks appeared to have been better prepared, through the previous devastating experiences from the Asian Crisis of 1996.

Post Global Crisis, there was a lot of debate about its effects on the Nepali economy and one school of thought always believed that there was no effect, with which I beg to differ.

Now a more fundamental question may be raised. Was the Central Bank in Nepal adequately prepared to handle the after effects of the Global Financial Crisis? Was its supervision good enough to ensure complete transparency in the financial reporting in the banking industry? A good debate can easily be made up of this – but the fact remains that the Nepali financial system did not learn the lesson from the Global Financial Crisis; and as a result, the glut in the real estate financing by the commercial banks and finance companies truly corroded the already fragile financial architecture of the economy. It is true that a number of good measures have been taken by the regulator over the last few years, yet the basic thing which is missing is the enforcement of good governance in the financial sector. To my mind, this should receive the highest importance in the ladder of priorities.

Now turning to the already leveraged position of the commercial banks of Nepal, and keeping in view the impending Basel III, I think the steps taken by the Central Bank with regard to higher capital requirement seem to be justified. However, quite a few questions remain unanswered with regard to the new capital requirement. The first thing comes to mind, “What is the basis of the quantum of the new capital requirement? The logical second question is the time frame – “is it realistic?” The third point is “will the new capital requirement drive the extant players in the commercial banking segment to consolidate?”

Considering the various factors and in particular the economic and socio–political conditions of Nepal it seems that both the quantum and time frame are unrealistic. On the issue of consolidation, it may be well argued that the extant promoters would in all likelihood not be able to inject the additional capital into the banks. Even if they go for rights issue, the depth and size of the Nepali Stock Market might as well find it too hard to absorb. Hence, the regulators should grant some thought to these debatable points and consider inviting the foreign financial institutions to participate in the process of consolidation. This would not only help the consolidation of the financial sector but also accelerate further reforms in the years to come.

The writer is a Member in the Board of Directors of Standard Chartered Bank Nepal Ltd. But the views expressed in this article are his personal and do not necessarily represent those of his institution.