Saudi banks will easily adapt to Basel III capital adequacy requirements that were approved last week in Switzerland and will be submitted in November for approval by the Group of 20, or G-20, Standard & Poor's Ratings Services (S&P) said on Saturday. The Basel III proposals on banking supervision could, according to S&P, strengthen banks' balance sheets as well as trigger fundamental changes in their business models and product pricing. However, if adopted as proposed, the Basel III proposals also run the risk of creating unintended consequences for parts of the financial system. These unintended consequences could include constraining banks' lending activities and their ability to trade on derivative markets, hampering the inter-bank lending market causing displacements in markets for high-quality liquid securities, and encouraging banks to shift to short-term lending. The implementation of the Basel III agreement won't put pressure on funding projects and companies in the Kingdom because local banks enjoy strong financial positions, and also because the Saudi government directly finances large-scale projects, the credit ratings agency said. Saudi banks are among the world's best positioned in terms of solvency capital and quality of capital, S&P said. Saudi banks have shown their ability to boost their capital during the boom years and until mid-2008, and were capable of maintaining a high capital adequacy ratio since that time, the credit rating agency said. Basel III's introduction of new liquidity standards could, according to S&P, significantly strengthen banks' liquidity positions and enhance the supervisory review process. However, an overly restrictive approach to the definition of liquid assets and requirements for funding certain types of assets with long-term funds could reduce bank profitability from their lending and trading activities. Some of Basel III's assumptions could, in our view, severely hamper the inter-bank lending market and cause displacements in the high-quality liquid securities markets. If Basel III's structural funding metric, which introduces minimum requirements for the use of longer-term and more stable funding sources, is implemented as proposed, banks could respond by shifting more toward short-term lending. “We believe that some level of mismatch between assets and liabilities is inherent in banking and necessary for banks to fulfill their role in the economy,” S&P said. S&P's credit analyst Bernard de Longevialle, said: “In our opinion, the Basel III proposals address many of the weaknesses in Basel II and should lead to stronger, more stable banks worldwide. However, they are also likely to affect parts of the financial sector in ways that regulators may not have envisaged.” Basel III will result in some banks having to make changes to their balance sheet structures or business models. “We expect smaller, deposit-funded retail banks to find it easier to comply with Basel III's more stringent liquidity and capital requirements than larger wholesale-funded institutions,” S&P report said. Although some of Basel III's proposals are consistent with S&P's view that risks in banks' trading books deserve higher capital charges, “we believe that the proposed regulatory capital charges under Basel III could be far higher than the counterparty risk losses endured by banks during the recent turmoil. If implemented in their present form, the proposals could create strong incentives for banks to move to qualified clearing houses.” Basel III's proposals could have significant effects on the derivatives markets and on financial institutions with large derivatives sales and trading businesses. “We believe that banks with significant trading activities with hedge funds or other financial intermediary counterparties would likely be most affected by Basel III's regulatory capital charge proposals,” S&P further said. In particular, the estimated multiplication by four to six times of counterparty risk compared to the current weighting, could have a major effect on the capital requirements of investment banks, for which counterparty risk often already accounts for more than 20 percent of total regulatory risk-weighted assets. The proposal could result in increased use of qualified clearing houses as counterparties for derivatives contracts. If OTC derivatives become too capital-costly for regulated financial institutions under Basel III, in our view this business (and its risks) might be driven to unregulated institutions such as hedge funds. Used as a supplement to risk-adjusted capital measures, both at the industry and at the specific bank level, S&P views Basel III's leverage ratio could be valuable and could help identify “outlier” banks. However it remains a raw measure for the purpose of bank capital adequacy analysis. Assigning too much weight to this measure could, in our view, incentivize banks to make riskier investment decisions. If Basel III's leverage ratio proposals are implemented, banks might well move away from low-risk, low-yielding businesses in favor of higher-risk, higher-return assets. In our view, the effectiveness of Basel III's leverage ratio proposals will depend on the definition of “leverage ratio”. If defined inaccurately, S&P said it could lead to outcomes that might be seen as undesirable from a broader perspective, such as for example a reduction in liquidity in the repo market as banks reduce their portfolios to manage the leverage ratio calculations. Basel III's proposal to implement countercyclical measures in the form of regulatory requirements should improve the creditworthiness of the banking industry, it added. The apparent procyclicality of the Basel II ratio was one of the factors behind our decision to develop our own risk adjusted capital measure. However, S&P said Basel III's proposed discontinuation of regulatory adjustments for unrealized gains and losses on securities or properties would likely exacerbate pro-cyclicality. Basel III's proposals for grandfathering hybrid capital instruments may create a lack of comparability in regulatory capital ratios for an extended period, S&P noted. “Grandfathering could also result in hybrid instruments still being included in regulatory capital measures despite their demonstrated ineffectiveness as a form of capital during the recent turmoil,” it said. - By Querubin J. Minas/with agency input __
