Who's afraid of Basel III? I am, and you should be too, because starting January 2013, tougher banking rules known as "Basel III" are expected to take effect. But why should we care? After all, Thailand is not a member of the Basel Committee, and aren't these rules supposed to have an impact on just banking operations anyway?
The Thai regulator does not need to adopt Basel III, but it can choose to do so, as it did with Basel I and II. The Bank of Thailand adopted the previous Basel rules to upgrade bank risk management practices to match international standards. Therefore, in the short term, it is the banking sector that will suffer most from stricter supervision. And the markets know this; when the Indian banking regulator announced last May they will embrace the new rules, followed by the Chinese regulator just last week, their banking stocks immediately tumbled. But what about the long-term impact? It may come as a surprise, but the changes could affect the well-being of your business. The long-term impact of the new rules is two-fold, but first, let's start with what exactly Basel III is.
Similar to the first two iterations, this third installment requires banks to hold higher levels of quality capital such as retained earnings and common shares, in order to sustain unexpected losses in a market downturn. Banks running short of capital can boost it either by lowering dividend payout or by raising funds in the capital markets. But unlike in Basel I and II, banks are now asked to hold a capital cushion called a "buffer" as a safeguard against a repeat of a Lehman Brothers collapse. Beyond that, Basel III introduces new features called liquidity and leverage tests. These new tests are there to make sure banks are not stressing their balance sheets with loans and investments without having adequate deposits and capital, technically preventing banks from biting off more than they can chew.
The combination of old and new features implies that banks have to start withdrawing their investments in "non-core" markets _ usually overseas emerging markets like Thailand _ to focus more on home or "core" markets, in order to save their capital and lower their leverage. This is also called "deleveraging". They could do so by adopting a "ring-fencing" business model whereby operations in those non-core markets will be run on a different balance sheet. This shift in business models would shock the Thai economy by drying up sources of external funding. To make matters worse, long-term investments to finance bulky projects will turn up on the wrong side of the Basel banking law because they are not so easy to liquidate in the event of loss. As a result, we could see a further gradual retreat of institutional funds that were originally devoted to infrastructure investment in the country. This is bad news for Thais because we need foreign money to facilitate infrastructure development _ one of the great catalysts for this country's economic growth.
Perhaps the most profound effect of foreign fund retractions will be on the development of the Thai capital market. Financial institutions have long been among the top investors in the Thai debt market, helping to generate liquidity and stability. That gets complicated when Basel III penalises corporate bonds rated below A-, again for being illiquid assets. Banks that struggle to comply with Basel liquidity tests will be scrambling to unwind their positions in poorly rated bonds, typically found in emerging markets. The result will be that illiquid markets will continue to be illiquid without adequate international investment funds. Similarly for Thailand, efforts to build a deeper, more liquid and less volatile debt market could prove to be futile.
And that is only the indirect effect that Basel III will have in other countries. Now that we have that covered, let's talk about the direct impact of the Bank of Thailand's plan to adopt Basel III, as early as next year.
First of all, simultaneous adoption is aggressive. Even the US has decided to delay implementation. In the past, the Bank of Thailand was careful not to adopt the first two Basel rules right away. This time it may seem to the Thai regulator that the status quo will weather the harsher regulatory reforms. And it is true; the central bank may have had a painful lesson from the 1997 Asian financial crisis but Thai banks are now fundamentally stronger, overcapitalised and underleveraged.
The impact of Basel III on Thai banking operations is likely to be small, especially compared to the true economic cost that will creep beyond the banking sector in the long run.
Because bank loans in Thailand still make up the majority of corporate financing, banks' limited capital will certainly hurt business expansions. The harsher capital rules mean banks will begin to brace themselves. Customer profiles will be subject to more scrutiny for risk-return balance. With capital becoming scarce, expect the rise in cost of financing to be pre-emptively passed through to bank customers. Infrastructure projects will be under added pressure; not only are foreign funds withdrawing due to deleveraging as mentioned before, but loans from domestic banks will also be harder to come by if Basel III is adopted in Thailand.
Under Basel III, it is difficult to imagine how the banks could reach the rate of credit growth to support economic progress.
Trade finance is another area of concern. Among bank financing products, small and medium-sized enterprises (SMEs), who are involved in trading business prefer a type of working capital financing called "letters of credit", or L/C. With this L/C documents, small businesses will be assured in pursuing overseas trades because risks in international payments are shifted to the issuing banks who guarantee the payments. The risks to banks are small, too. On average, the chance of L/C defaulting is less than with normal loans because it is short term and the source of funds to be settled on the due date is known, or "self-liquidating".
The bad news is that Basel doesn't think so. In the context of leverage level, the rules ask that banks apply the full guaranteed amount on L/C, instead of only its risk-adjusted amount as was the norm in the past rules. This could force smaller banks to put a wrap on their trade financing business altogether, as it is already low-margin. So how can SMEs finance trade cheaply? This is discouraging for an economy like Thailand's which depends on the well-being of its international trade and SMEs. As a side effect, we could see renewed popularity of a shadow banking system that offers similar guarantees for SMEs to satisfy trading needs but is otherwise unregulated.
Perhaps we must ask ourselves if fully and hastily adopting Basel III is unnecessarily importing problems from the West, while in the process risking the economy's health. We cannot escape the indirect impact of Basel III's adoption in other countries, but we can certainly choose the right regulatory path and timeframe that do not interfere with national efforts for growth.
There is an effort from banks across Asia to call for a delay in implementation until nation-specific rules can be established to match distinct national circumstances and requirements. For Thailand, infrastructure development is still imperative; while international trade and SMEs are still the Thai economy's lifeline that need support, not control. We could do without these new rules that discourage those things that are vital to us, particularly when the Thai version of capital rules have been tougher than required since Basel I.
Dr. Sutapa Amornvivat is Chief Economist and Executive Vice President at Siam Commercial Bank. She has international work experience at IMF, ING Group and Booz, Allen, Hamilton. She received a BA from Harvard and a PhD from MIT.