[2]<\/sup><\/a>.<\/p>\nOn the basis of the information disclosed in the June 30, 2017 and December 31, 2016 financial statements of banks we determined that banks in green (GCB, Barclays Bank of Ghana Ltd. and Zenith Bank Ghana Limited) are the only banks that might not require additional capital to meet the minimum capital requirements for 2018.<\/p>\n
As shown in the table below, the industry would potentially need to raise GH\u00a28.6 billion (in absence of financial
\nstatements available for National Investment Bank Ltd, OmniBank Ghana Limited, the Beige Bank Limited, the
\nConstruction Bank (Gh.) Limited, GHL Bank Limited and ARB Apex Bank Ltd, I assumed each of them will need GHS 400
\nmillion) by 31 December 2018 (ignoring IFRS 9 impacts, profits for 2017, and potential consolidations).<\/p>\n
This is estimated to be about 78% of June 2017 total shareholder\u2019s funds of GH\u00a211 billion per the July 2017 Banking sector report 10.<\/p>\n
This estimate excludes potential impact of new accounting requirement (IFRS 9) which its capital impact is GHS 283 million
\n(see Q & A 14 below)<\/p>\n
![\"banks-table\"](\"http:\/\/citifmonline.com\/wp-content\/uploads\/2017\/09\/banks-table.jpg\")
<\/p>\n
Q14 :\u00a0 I understand there is a new accounting standard that will require Banks to recognize \u00a0loan loss reserves faster than before and such accounting standard is effective January 1 , 2018, tell us a little bit about \u00a0the accounting standard and its impact on current levels of loan loss reserves, proposed capital requirements and capital adequacy<\/strong><\/p>\n\u00a0<\/strong>The new accounting standard that will require faster level of loan loss reserve starting January 1, 2018 is called IFRS 9 Financial Instruments. IFRS 9 will require banks to show their losses earlier than in the past. Overall, the losses themselves do not change in total over the life of the loans; only the timing of their recording by the bank will be different. The new approach is seen as more timely and it reflects the underlying economics more closely since expected future losses are already priced in the interest rate charged on the loans.<\/p>\nBefore IFRS 9, accounting rules forced banks to \u201cwait\u201d for a loss event before recording a loss against a loan asset. This was the case even when banks expected that a percentage of their loans would not be paid back in full. When the downturn came they had to catch up by recording significantly larger losses all at once. The result was the heavy criticism of banks during the financial crisis for providing \u201ctoo little too late\u201d.<\/p>\n
After long discussions it was agreed that this was not helpful; losses should be booked when they are expected as well as when they actually occur. Accounting rules have been changed (in the US under the Current Expected Credit Loss (CECL) model and under IFRS 9 in the rest of the world) to anticipate losses from the day the loan is granted: this is what accountants mean by moving from an \u201cincurred loss model\u201d (which needs an event to occur before a loss is recorded) to an \u201cexpected loss model\u201d.<\/p>\n
The expected loss model in IFRS 9 is complex and it requires banks to look into the future and to estimate the range of possible economic scenarios that might occur. Banks will have to decide what they think is going to happen to their customers and when. Although this will be done on a portfolio rather than individual borrowing level, they have to consider different circumstances, wider economic events and extreme conditions. This may sound onerous but anticipating future losses in this way will promote more prudent (i.e. later) recording of profits on the loans.<\/p>\n
It is helpful to understand that the estimate of losses at any point in time is just that, an estimate. It is also worth noting that unforeseen future events cannot, by definition, be factored into these calculations, so economic shocks can still cause significant and sudden additional losses. This is one of the reasons banks have to hold substantial buffers of capital to absorb such losses if they arise and this is tested regularly by prudential regulators.<\/p>\n
The overall impact of IFRS 9 will be that banks will report their losses sooner, but these are not new losses. They have been reflected in the lending decisions and only the timing of their recognition is affected.<\/p>\n
While this treatment is more prudent, there are some real challenges. Measurement is highly subjective because it relies on an estimate. This element of forecasting will potentially lead to volatile results. When recession is predicted losses will accelerate, even if current economic circumstances are benign. Comparison between banks will be difficult since their view of the future could be radically different. Analysts looking at bank financial statements may find this problematic.<\/p>\n
The international accounting standard (IASB) field work on the \u00a0impact assessment of the new accounting standard indicates that allowances could increase as follows:<\/p>\n
\n- Between 30% and 250% for mortgage portfolios<\/li>\n
- Between 25% and 60% for non-mortgage portfolios<\/li>\n<\/ul>\n
The European Banking Authority (EBA) Impact assessment is a30% increase in current loan loss reserve.\u00a0 Also, A Deloitte survey shows approximately 50 percent more allowance as compared to the current levels of provisioning.<\/p>\n
An increase in balance sheet allowances under IFRS 9 can result in a material reduction in shareholders\u2019 equity.<\/p>\n
If balance sheet allowances increase by >40%then core Tier-1 capital ratios for many banks would be materially affected. All else equal, this assumes that the impact from accounting transition flows directly to regulatory capital.<\/p>\n
Q15 :\u00a0 I understand there is a new accounting standard that requires Banks loan loss reserves to be recognized faster than before and such accounting standard is effective January 1 , 2018, should Banks consider that in their Capital planning for December 31, 2018.<\/strong><\/p>\nAbsolutely Yes, In addition to the new accounting standard, Banks should stress scenarios of economic and credit performance from now till end of December 31, 2018 to enable them plan for the capital required.<\/p>\n
Q16: what are some of the business and strategic implications Banks should consider in relation to the new approach to recognize loan reserve under IFRS 9<\/strong><\/p>\nTo help banks get ahead, I have identified strategic actions in five areas: portfolio strategy, commercial policies, credit management, deal origination, and people management.<\/p>\n
\n- Adjusting portfolio strategy to prevent an increase in P&L volatility<\/strong><\/li>\n<\/ol>\n
IFRS 9 will make some products and business lines structurally less profitable, depending on the economic sector, the duration of a transaction, the guarantees supporting it, and the ratings of the counterparty. These changes mean that banks will need to review their portfolio strategy at a much more granular level than they do today.<\/p>\n
Economic sector.<\/em>\u00a0The forward-looking nature of credit provision under IFRS 9 means that banks will need to reconsider their allocation of lending to economic sectors with greater sensitivity to the economic cycle.<\/p>\nTransaction duration.<\/em>\u00a0The more distant the redemption, the higher the probability that the counterparty will default. Under IFRS 9, stage 2 impairments are based on lifetime ECL\u2014the expected credit losses resulting from all possible default events over the expected life of the financial instrument\u2014and will therefore require higher loan-loss provisions.<\/p>\nCollateral.<\/em>\u00a0Unsecured exposures will be hit harder under the new standard. Collateral guarantees will help mitigate the increase in provisions for loss given default under IFRS 9, particularly for exposures migrating to stage 2.<\/p>\nCounterparty ratings.<\/em>\u00a0IFRS 9 imposes heavier average provision \u201cpenalties\u201d on exposure to higher-risk clients, so counterparty ratings will have a direct impact on profitability. Industry observers expect provisioning for higher-risk performing clients to rise sharply once the new framework is in place.<\/p>\nThis shift in structural profitability suggests that banks should, where possible, steer their commercial focus to sectors that are more resilient through the economic cycle. This will reduce the likelihood of stage 1 exposures migrating to stage 2 and thereby increasing P&L volatility. Higher-risk clients should be evaluated with greater care, and banks could introduce a plafond (credit limit) or other measures to restrict the origination of products most likely to be vulnerable to stage 2 migration, such as longer-duration retail mortgages and longer-term uncollateralized facilities, including structured-finance and project-finance deals.<\/p>\n
Banks could also consider developing asset-light \u201coriginate to distribute\u201d business models for products and sectors at higher risk of stage 2 migration. By originating these products for distribution to third-party institutional investors, banks could reduce their need for balance-sheet capacity for risk-weighted assets and funding, and avoid the large increase in provisions they would otherwise have to make for stage 2 migration. Pursuing such a strategy would involve developing an analytical platform that can calculate fair-value market pricing for each corporate loan and enable banks instantly to capture opportunities for asset distribution in the market.<\/p>\n
\n- Revising commercial policies as product economics and profitability change<\/strong><\/li>\n<\/ol>\n
IFRS 9 will reduce profitability margins, especially for medium- and long-term exposures, because of the capital consumption induced by higher provisioning levels for stage 2. In particular, exposures with low-rated clients and poor guarantees will require higher provisions for stage 2 migration. For loans longer than ten years, provisions for lifetime expected credit losses may be up to 15 to 20 times higher than stage 1 provisions, which are based on expected loss over 12 months. To offset this negative impact on their profitability, banks can adjust their commercial strategies by making changes in pricing or product characteristics:<\/p>\n
Pricing.<\/em>\u00a0When possible, banks should contractually reach agreement with clients on a pricing grid that includes covenants based on indicators that forecast the probability of migration to stage 2, such as the client\u2019s balance-sheet ratio and liquidity index. If a covenant is breached, the rate would increase\u2014for example, by 10 to 20 basis points to compensate for the extra cost of stage 2 for exposures between five and ten years, and by 25 to 35 basis points for exposures longer than ten years. If flexible pricing is not possible, the expected additional cost of a stage 2 migration should be accounted for up front in pricing. This cost should be weighted by the expected time spent in stage 2: for example, 3 to 5 basis points on average for exposures with a maturity of five to ten years, and 5 to 10 basis points for those longer than ten years.<\/p>\nProduct characteristics.<\/em>\u00a0Banks could adjust maturity, repayment schedule, pre-amortization period, loan-to-value, and break clauses to reduce the impact of IFRS 9 on their profitability. In particular, they should aim to reduce their maturity and amortization profile by providing incentives to relationship managers and clients to shift to shorter-term products, and by introducing new products or options that allow early redemption or rescheduling.<\/p>\n\n- Reforming credit-management practices to prevent exposures from deteriorating<\/strong><\/li>\n<\/ol>\n
Under IFRS 9, the behavior of each credit facility after origination is an important source of P&L volatility regardless of whether the exposure eventually becomes nonperforming. Banks therefore need to enhance performance monitoring across their portfolio and dramatically increase the scope of active credit management to prevent credit deterioration and reduce stage 2 inflows. Different approaches can be used to do that, including an\u00a0early-warning system or a rating advisory service.<\/em><\/p>\nForward-looking early-warning systems<\/em>\u00a0allow banks to intercept positions at risk of migrating to stage 2. This system would extend the scope of credit monitoring and shift responsibility for it from the credit department to the commercial network. \u201cSignificant deterioration\u201d will be measured on a facility rather than a counterparty level under IFRS 9, so virtually every facility will need to be monitored to preempt the emergence of objective signs of deterioration, such as 30 days past due. Monitoring facility data and ensuring that information about guarantees is complete and up to date will be vital in preventing the expensive consequences of migrations to stage 2.<\/p>\nThe commercial network should be fully involved in a structured process through which risk management flags any facility approaching migration and identifies the likely reason: for instance, a deterioration in a debtor\u2019s short-term liquidity or a problem with data quality. An algorithm\u2014or a credit officer\u2014then assigns possible remediation and mitigation actions, such as opening a short-term facility to solve a liquidity issue or updating balance-sheet indicators to\u00a0improve data quality. Finally, the relationship manager sees the flagged position and proposed remedial actions on the system and contacts the client to discuss a set of strategies. These might include helping the client improve its credit rating through business or technical measures like those just mentioned, taking steps to increase the level of guarantees to reduce stage 2 provisioning, and adjusting timing and cash flows in the financing mix to the assets being financed so that long-term maturities are used only when necessary.<\/p>\n
By a\u00a0rating advisory service<\/em>, banks could advise clients on ways to maintain good credit quality, provide solutions to help them obtain better terms on new facilities, and reduce their liability to migrate to stage 2. Banks could offer a fee-based service using a rating simulation tool that enables credit officers and relationship managers to propose how clients could improve their rating or prevent it from worsening. The tool would need to include a macroeconomic outlook and scenarios to forecast how different economic sectors might evolve; a list of actions for improving or maintaining the client\u2019s rating in situations such as a drop in revenues, declining profitability, or liquidity issues; and a simulation engine to assess how ratings may evolve and what the impact of various actions could be. Over time, the bank could build up a library of proven strategies applicable to a range of client situations.<\/p>\n\n- Rethinking deal origination to reflect changes in risk appetite<\/strong><\/li>\n<\/ol>\n
IFRS 9 will prompt banks to reconsider their appetite for credit risk and their overall risk appetite framework (RAF), and to introduce mechanisms to discourage credit origination for clients, sectors, and durations that appear too risky and expensive in light of the new standard.<\/p>\n
For example, if banks consider global project finance to be subject to volatile cyclical behavior, they may decide to limit new business development in such deals. To react quickly and effectively to any issues that arise, they should also adjust the limits for project finance in their RAF, review their credit strategy to ensure that new origination in this area is confined to subsegments that remain attractive, and create a framework for delegated authority to ensure that their credit decisions are consistent with their overall strategy for this asset class.<\/p>\n
\n- Providing new training and incentives to personnel to strengthen the commercial network<\/strong><\/li>\n<\/ol>\n
As banks are forced to provide for fully performing loans that migrate to stage 2, their commercial network will need to take on new responsibilities.<\/p>\n
In particular, relationship managers will assume a pivotal role, becoming responsible for monitoring loans at risk of deterioration and proposing mitigation actions to prevent stage 2 migration, as noted above. However, most relationship managers have sales and marketing backgrounds, and though they typically originate loans, they do not actively manage them thereafter. As a result, they will need to be trained in new skills such as financial restructuring, workout, and capital management to help them deal with troubled assets effectively.<\/p>\n
In addition to introducing training programs to build these capabilities, banks should review their incentive systems to ensure that relationship managers (RMs) are held accountable for any deterioration in credit facilities in their portfolio. The RMs should be evaluated and compensated on an appropriate risk-adjusted profitability metric, such as return on risk-weighted assets, return on risk-adjusted capital, or economic value added, with clear accountability for how well stage 2 costs are managed.<\/p>\n
Q17: What are some of the sound capital planning tactics banks should adopt now<\/strong><\/p>\nThe Basel Committee on Banking Supervision (BCBS) publication 277 called\u00a0 A Sound Capital Planning Process: Fundamental Elements provides four fundamental components of a sound capital planning process: (a) Internal control and governance (b) Capital policy and risk capture (c) Forward-looking view (d) Management framework for preserving capital<\/p>\n
The Basel Committee views capital planning as a necessary complement to a robust regulatory framework. Sound capital planning is critical for determining the prudent amount, type and composition of capital that is consistent with a longer-term strategy of being able to pursue business objectives, while also withstanding a stressful event. More broadly, the provision of better capital planning practices furthers the Basel Committee\u2019s objective of consistently implementing the Basel III framework as a means of maintaining the resilience of the global financial system.<\/p>\n
\n- Internal control and governance<\/li>\n<\/ul>\n
It is important that a capital planning process reflects the input of different experts from across a bank, including but not limited to staff from business, risk, finance and treasury departments. There should be a strong link between the capital planning, budgeting and strategic planning processes within a bank. Collectively, these experts provide a view of the bank\u2019s current strategy, the risks associated with that strategy and an assessment of how those risks contribute to capital needs as measured by internal and regulatory standards. Otherwise, banks may run the risk of developing capital plans that do not.<\/p>\n
As a general matter, both senior management and the board of directors4 are involved in the capital planning process.5 Sound practice typically involves a management committee or similar body that works under the auspices of a bank\u2019s board of directors and guides and reviews efforts related to capital planning. Typically, the board of directors sets forth the principles that underpin the capital planning process. Those principles may include the forward strategy for the bank, an expression of risk appetite and a perspective on striking the right balance between reinvesting capital in the bank\u2019s operations and providing returns to shareholders. Banks with stronger governance of the capital planning process require the board of directors or one or more committees thereof to review and approve capital plans at least annually. Those same bodies are also required to consider the outcome of the capital planning process when appraising business developments and strategy. The analysis captured in a capital plan informs the capital actions contemplated by the board of directors including, for example, whether to reconfirm or change a common stock dividend or common stock repurchase plan and\/or issue regulatory capital instruments. In cases where this decision-making has been delegated to one or more committees of a board of directors, approval of the capital plan typically falls within the remit of the board\u2019s risk committee.<\/p>\n
\n- Capital policy and risk capture<\/li>\n<\/ul>\n
An important input to a capital policy is an expression of risk tolerance by management and the board of directors. A risk tolerance statement is approved by the board of directors and renewed annually. It directly informs the bank\u2019s business strategy and capital management, including, for example, through the establishment of return targets, risk limits and incentive compensation frameworks at the group and business unit levels. As a general matter, the credibility of a bank\u2019s capital planning can be questioned if the process does not adequately reflect material risks, some of which may be difficult to quantify. Banks routinely quantify and hold capital against those risks that are specified in the minimum requirements or Pillar 1 of the Basel II\/III regimes. Those risks include credit, counterparty, market and operational risk. Banks with better practices have a comprehensive process in place to regularly and systematically identify, and understand the limitations of, their risk quantification and measurement methods.6 In addition, banks seek to capture in their capital plans those risks for which an explicit regulatory capital treatment is not present, such as, but not limited to, positions that result in concentrated exposures to a type of counterparty or industry, reputational risk and strategic risk. It is also important to establish clear links between capital and liquidity monitoring, considerations that banks did not feature as prominently in past evaluations of capital adequacy.<\/p>\n
\n- Forward-looking view<\/li>\n<\/ul>\n
Another key element of a sound capital planning process is stress testing or scenario analyses. These techniques are often used to obtain a forward view on the sufficiency of a bank\u2019s capital base. As noted in the\u201cPrinciples for sound stress testing practices and supervision\u201d\u00a0 issued by the Basel Committee in May 2009, an effective capital planning process requires a bank both to assess the risks to which it is exposed and to consider the potential impact on earnings and capital from an assumed economic downturn. In other words, stress testing needs to be an integral component of the capital planning process. Indeed, stress testing and scenario analyses provide a view as to how the bank\u2019s capitalisation could be jeopardised if there were a dramatic bank-specific or economic change. Absent such a component, a bank\u2019s capital plan would be highly vulnerable, and thus any actions pursuant to it may not adequately insulate the bank against future adverse developments. Stress testing or scenario analyses are quantitatively based, incorporate all relevant risks to the bank and conservatively capture and account for changes in key risk factors across all portfolios and businesses under appropriately severe forward-looking scenarios. In addition, sound practice is evidenced in the repeatability of stress testing and the capability of performing ad hoc scenarios outside the normal stress testing procedures.<\/p>\n
For the purpose of capital planning, financial institutions estimate the impact of at least a baseline and a downturn scenario that incorporate a combination of economic, market and bank-specific indicators. The impact of a scenario reflects estimated changes to a bank\u2019s revenue, loss, balance sheet, exposure measures and risk-weighted assets. Of the banks observed, leading practice involved exploring the impact of scenarios that captured plausible, severe market-wide and idiosyncratic events that could negatively impact the bank. The Basel Committee\u2019s Principles for sound stress testing practices and supervision discusses various techniques that could be used to develop a robust stress test.<\/p>\n
\n- Management framework for preserving capital<\/li>\n<\/ul>\n
For a capital planning process to be meaningful, a bank\u2019s senior management and directors should rely on it to provide them with views of the degree to which a bank\u2019s business strategy and capital position may be vulnerable to unexpected changes in conditions. Sound practice entails senior management and the board of directors ensuring that the capital policy and associated monitoring and escalation protocols remain relevant alongside an appropriate risk reporting and stress testing framework. In addition, they are responsible for prioritising and quantifying the capital actions available to them to cushion against unexpected events. In practice, those actions include reductions in or cessation of common stock dividends, equity raises and\/or balance sheet reductions. This last set of potential actions could, for instance, include the disposition of capital markets inventory, monetising business units or reducing credit origination. It is critical that management teams assess the feasibility of the proposed contingent actions under stress, including potential benefits and long-term costs, and have a high degree of confidence that such actions can be executed as described. Otherwise, they should not be captured in a bank\u2019s capital plan.<\/p>\n
–<\/p>\n
Author: Emmanuel Akrong (Credit Consultant)<\/p>\n
Email: emmanuel.akrong@gmail.com<\/p>\n","protected":false},"excerpt":{"rendered":"
Capital requirement is the minimum amount of capital a bank or other financial institution has to hold as required by its financial regulator. A bank\u2019s capital adequacy ratio on the other hand is expressed as a ratio of equity as a percentage of risk-weighted assets. These requirements are put into place to ensure that these […]<\/p>\n","protected":false},"author":14,"featured_media":37044,"comment_status":"open","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":[],"categories":[121,32,171,11],"tags":[],"yoast_head":"\n
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