Application of the Basel Accords in Latin America

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By: Mr. Mark C. Miller, CEIS Review Inc.

CEIS Review maintains an active practice offered to international clients, particularly those throughout Latin America. While every geographic area does have some financial particularity to itself, a universal need in the lending community is being able to articulate and manage Credit Quality standards in anticipation of capital requirements. A widely discussed topic in relation to Credit Quality and capital requirements is that of the Basel Accords. In this article we examine how the most recent version of the accords differs from previous versions, examine the timeline of actual application of the prior versions of the accords, as well as provide some insight as to which Latin American countries appear to be primed to meet the new standards of the most recent iteration of the accords.

Latin American banks are well capitalized and in a much better position to meet Basel III capital requirements than banks in developed countries. While most press coverage of Basel III has emphasized the new capital standards, the new international banking regulations also include a Liquidity Coverage Ratio (LCR) and a Net Stable Funding Ratio (NSFR). Basel III’s new capital framework includes a new definition of capital and new capital standards, with a phase-in period through 2019. In Latin America, Argentina, Brazil and Mexico have formally incorporated Basel III capital rules in their banking regulations. Other Latin countries are expected to do the same.

Basel III defines high-quality capital as common shares and retained earnings, with a very limited number of other instruments eligible for inclusion as Tier I equity (unlike Basel II, which allowed a much broader range of Tier I equity instruments). Basel III also tightens the rules on the risk-weighting of bank assets. In summary, Basel III places more focus on high-quality capital and sets higher, more stringent, capital requirements. So far, it appears that banks across Latin America are strongly positioned to comply with the new Basel III capital requirements. There are two main Basel III capital requirements: Tier I Capital to Risk-Weighted Assets of 8.5% or above, and Total Capital to Risk-Weighted Assets of 10.5% or higher.
In March 2013, Mexico’s main bank regulator, the Mexican National Banking and Securities Commission (CNBV) for the first time publicized the banks’ capital ratios calculated in accordance with Basel III. At the end of January 2013, all banks in Mexico exceeded the Basel III Net Capital Risk-Weighted minimum for 2019 of 10.5%. Mexico’s Banorte said that at the end of 2012 it had a Basel III total capital ratio of 15.7%; however, it fell to 13.2% with the acquisition of local pension fund administrator Afore Bancomer. Banamex had a strong Basel III total capital ratio of 15.7%; Santander Mexico, 15.1%, while BBVA Bancomer had a 16.3% total capital to risk-weighted assets Basel III ratio.

The strong capital position of Mexican banks is confirmed in the Standard & Poor’s paper “What Does the Rollout of Basel III’s Capital Rules Hold for Latin American Banks?” This analysis was published in September 2013 and surveys a number of countries. It notes that Mexico was the first Latin American country to implement Basel III rules. S&P reports that Chile is “planning for a gradual migration into Basel III, with the first deadline in 2015 and full implementation by 2019.” The tone on Chile is positive, consistent with a Chilean Central Bank study based on August 2012 data from the country’s main bank regulator showing that the Chilean banking system would comply with Basel III capital guidelines.

While there are some areas of concern, indications are that other Latin countries are well positioned to comply with Basel III capital standards. For example, an Inter-American Development Bank (IDB) policy paper published in December 2011 showed that the banking systems of Colombia, Peru, Ecuador and Bolivia would all meet the Basel III capital requirements without raising additional capital. That being said, questions have been raised about Colombia. For example, in Colombia, subordinated debt issued by banks usually lacks the equity-like characteristics defined by Basel III and present in other Latin countries such as Mexico, Peru and, more recently, Brazil. Also, Colombian accounting for acquisitions creates difficulties in light of Basel III excluding intangibles and goodwill from Tier I capital.
While banks in Mexico, Colombia and Brazil have met Basel III capital requirements, it appears likely that Colombian and Brazilian institutions will need to raise capital. This is based on the high rates of asset growth typical of Colombian and Brazilian banks. Brazil’s Central Bank calculates that Brazilian banks will need to increase capital during the 2016 – 2019 period because of asset growth. In September 2013, Banco do Brasil amended the terms of $3.75 Bn worth of hybrid Tier I securities to make them compliant with Basel III. Santander Brasil is reportedly considering issuing hybrid securities under the new Basel III framework; the perpetual non-call instrument would convert to equity if the bank’s capital ratio falls below a pre-defined trigger. To be considered capital under Basel III, subordinated securities must have features that make them more expensive for issuing banks because they have provisions like principal reduction, conversion into shares and skipping coupon payments. At the same time that Brazilian banks have been making financial news for their use of complex instruments, Standard & Poor’s has expressed confidence that banks in Brazil will be able to raise equity by issuing common shares.

In Argentina, Basel III capital standards were legislated in February 2013. Capitalization levels in Argentina are widely viewed as sound. However, Standard & Poor’s has doubts about credit quality and risk-weighting in Argentina.

Central America’s BAC Credomatic reported a Tier I capital ratio of 13.87% at year-end 2012; and the bank’s management expects to continue to comply with Basel III capital requirements through organic growth, profit growth and increased retained earnings.
The first Basel capital accord, Basel I, was published in 1988. Published in 2004, the Basel II accord was longer and more complex. As a result of the 2008-2009 financial crisis, Basel III was drafted in order to correct the main problems detected in Basel I and II. In Latin America and other markets, certain Basel II guidelines are still in the process of being implemented. In June 2013 Mexico’s CNBV published the guidelines for calculating loan provisions based on Basel II standards. This means that, for wholesale or business-banking loans and leases, loss provisions must be based on expected losses (not historical losses). Basel II mandates that expected losses are, with some exceptions, the product of multiplying Probability of Default (“PD”) by Loss Given Default (“LGD”) by Exposure at Default (EAD or amount outstanding). The PD should be directly correlated to the credit risk rating. Therefore, many banks in Latin America are being forced to revise their risk-rating models; Chile, El Salvador, Nicaragua and Venezuela appear to be lagging behind in this process. On the other hand, Brazil appears to be the Latin American leader in Basel implementation.

While Basel II rules for loan-loss provisions are currently being put into practice in Latin America, Basel III is still evolving. The Basel Committee, composed of 27 members, still has work to do on long-term liquidity requirements, and capital requirements for trading-book assets rules and complex securitizations. The Committee is also working to ensure that risk-weighting is done consistently across countries. So far, the overwhelming focus of Basel III analysis has been on the new capital requirements; however, Basel III also includes a Liquidity Coverage Ratio (LCR) and a Net Stable Funding Ratio (NSFR).

The LCR calls for banks to hold enough liquid assets to cover a 30-day funding freeze. The Bank of International Settlements (BIS), the entity propagating these new rules, gave guidance in January 2014 on what exactly constitutes a liquid asset. Also in January 2014, BIS presented a consultation document on the NSFR, a measure of term funding in proportion to a bank’s assets. According to Andrew Cornford of Observatoire de la Finance in Geneva, Switzerland, “There can be little doubt that the designers of these rules based them on conditions in highly advanced financial markets.” Also according to Cornford, “Peru is considering longer phase-in periods than those specified in Basel III rules, 2015 for the LCR and 2018 for the NSFR as well as an exemption from the rules for certain small, specialized banks.” These target dates are the same as those being used by Brazil.

Basel rules may have been drawn up with more advanced countries in mind, but Latin American banks have some overall advantages in implementing the new rules. For example, compared to banks in developed countries, Latin bank balance sheets tend to be more traditional, with loans making up a larger percentage of assets; with fewer derivatives and complex securitizations, the risk-weighting of assets is more straight-forward for Latin banks. Regarding the new LCR, investment portfolios in Latin America more heavily weighted toward government securities, simplifying the identification of liquid assets.

While banking systems across Latin America are generally well capitalized, much of the analysis has been based on system-wide figures, meaning that individual banks could be non-compliant. Mexico is the exception, where all individual banks were analyzed and found to meet the Basel III capital requirements. Recent rates of asset growth among Latin American banks suggest that additional capital will have to be raised. Complying with Basel II standards on loan-loss provisions requires some Latin banks to change their risk rating methodologies; banks’ Loss Given Default (LGD) methodologies also need to conform to Basel II guidelines. Basel III rules on LCR and NSFR are still evolving, and specific rules could present challenges for Latin banks. However, the overall conclusion is that Latin American banks appear to be in good shape, with sufficient amounts of Tier I capital.

[1] Jose M Perez-Gorozpe and Amalia Bulacios, “What Does The Rollout Of Basel III’s Capital Rules Hold For Latin American Banks?” Standard & Poor’s Ratings Direct, September 18, 2013.

[2] Arturo Galindo, Liliana Rojas-Suarez and Marielle del Valle, “Capital Requirements under Basel III in Latin America: The cases of Bolivia, Colombia, Ecuador and Peru, Inter-American Development Bank Policy Brief, December 2011.

[3] Andrew Cornford, “Comments from the Perspective of Basel III on the report of the Financial Stability Board (FSB) concerning potential unintended consequences of the current programme of regulatory reforms on emerging market and developing economies”, Observatoire de la Finance, Geneva, August 2012.