Basel III and its implications for banks in Vietnam

Ten commercial banks in Vietnam have announced they have completed the implementation of Basel III – a risk management standard used in banking operations. Other banks have also applied some of the requirements of Basel III, demonstrating their efforts to gradually upgrade risk management practice and capital adequacy ratios, while ensuring financial market stability.

First, regarding capital quality and adequacy. Basel III has raised the minimum common equity tier 1 ratio to 4.5 per cent with an additional capital buffer of 2.5 per cent, bringing the minimum requirement to 7 per cent. This increases the overall capital adequacy ratio to 10.5 per cent compared to the current 8 per cent.

Should banks fail to meet these updated requirements, stricter monitoring measures shall be established, including restrictions on dividends distributed from retained earnings.

Compared to Basel II, Basel III introduces new requirements and has significant impacts on banking operations.

This is an important revision to help banks set a capital buffer to prevent violations of minimum adequacy ratios while giving supervisory authorities enough time before an actual failure can occur. 

Furthermore, Basel III sets out separate capital adequacy ratios for common equity and tier 1 capital, highlighting the importance of the quality and soundness of a bank's own capital structure rather than solely focusing on the total capital adequacy.

In comparison, Circular No.41/2016/TT-NHNN, which regulates capital adequacy ratios for banks and foreign bank branches, does not specify ratios for different capital components. This is a focal point that needs to be addressed in the future to further enhance the quality of capital in the commercial banking system.

Second, a counter-cyclical capital buffer to enhance macroeconomic stability can help counter a common issue seen during periods of strong economic growth, when systemic risks in the banking sector are expected to increase (due to relaxed lending standards, overvaluation of collateral assets, and others related issues).

Conversely, during economic downturns, credit can tighten excessively, exacerbating the problem. 

With this requirement, counter-cyclical capital buffers are mandated to be added during periods of economic expansion and reduced or completely removed during recessionary periods to mitigate the cyclical nature of the economy.

Managing this smoothly will help banks maintain sufficient capital reserves during growth periods and offset capital declines during crises.

This requirement has been implemented by many central banks. The size of the capital buffer can be calculated based on macroeconomics such as credit growth, GDP factors, and specific factors of each bank such as risk profiles and stress test results.

This could be a good alternative in the future when the State Bank of Vietnam considers moving away from its credit limit room regime. 

The third aspect involves regulations that allow write-down and converting capital instruments (such as convertible bonds) into equity when financial institutions fail to meet minimum capital adequacy ratios. This regulation will provide an additional mechanism for banks to ensure safety in a crisis.

Fourth are adjustments to the standardized approach to estimate capital charges for credit, market, operational, and counterparty credit risks, and the introduction of credit valuation adjustment risk.

These adjustments aim to enhance the sensitivity of risk-based capital estimation and the comparability of capital requirements based on risk profiles of commercial banks. Among these adjustments, the credit valuation adjustment risk is a new requirement that was not considered in the capital estimation method of Basel II.

Fifth, Basel III presents new and stricter requirements in internal capital estimation models, highlighted by requirements for model validation, demonstration of model application in day-to-day management, and most notably the introduction of an output floor. 

The output floor limits the level of capital estimated from internal models for all types of risks to a floor level calculated using the standardized approach of Basel III.

Sixth, Basel III introduces a new ratio called the leverage ratio, understood as a supplementary ratio based on the estimation of tier 1 capital over total exposure (on- and off-balance sheet) before adjusting for risk weight.

The leverage ratio aims to limit banks from excessively using debt instruments (both on-balance sheet and off-balance sheet) while maintaining a healthy capital adequacy ratio. This isn't considered a major issue for banks in Vietnam.

Seventh, Basel III introduces additional liquidity monitoring metrics. Based on the lessons learned from the 2008 crisis, Basel III has introduced two key ratios: the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR). 

The LCR aims to enhance a bank's resilience to short-term liquidity stress by requiring banks to hold sufficient high-quality liquid assets to meet their net cash outflow needs over a 30-day period during a crisis.

It is important to note that Circular No.22/2019/TT-NHNN, which sets limits and safety ratios for banks and foreign bank branches, already includes a requirement for a 30-day liquidity coverage ratio that is similar to the LCR. However, there are some differences between Circular 22 and Basel III, particularly in terms of the calculation of cash inflows and outflows without considering the crisis factor.

The NSFR, on the other hand, aims to complement the LCR by encouraging banks to maintain stable funding sources to meet their cash flow needs over a one-year period. The maximum ratio of short-term funding used for medium and long-term lending in Circular 22 has a similar meaning to the NSFR.

However, the NSFR provides a more comprehensive assessment of a bank's medium and long-term liquidity position by applying different stable funding and stable funding usage factors for different categories of assets and liabilities. 

Eighth, Basel III enhances regulations on the management and measurement of interest rate risk on the banking book.

In particular, Basel III introduces provisions for modeling the behavior of balance sheet items with cash flow characteristics that differ from contractual terms, such as early repayment behavior or early withdrawal of funds.

These regulations aim to improve the quality of capital measurement for interest rate risk on the banking book and provide a more accurate reflection of the cash flow nature of these instruments.

Ninth, Basel III introduces enhanced monitoring of large exposures, aiming to minimize risk concentration and systemic risk among financial institutions. 

Different from Vietnam's current principles of concentration risk calculation, which focus on outstanding credit loans, Basel III expands the scope of large exposure to include risk exposure arising from counterparties/customers (other than outstanding credit) such as derivatives or repo/re-repo. In addition, definitions of connected counterparties have also been significantly expanded compared to Vietnam's current regulations.

According to Circular 22, a group of connected counterparties are mainly identified via ownership relationships or family relationships, meanwhile, Basel III adds criteria based on economic interests.

As a result, two counterparties are considered to be connected if they have crucial economic interdependence without the need of any ownership or family relationships. This regulation will have a major impact on banks' management of concentration risk, such as data consolidation for reporting and lending orientation. For example, certain supply chain financing products might be the first to suffer.

Tenth, by improving disclosure requirements, Basel III promotes greater transparency in banks' risk management activities beyond the simple safety ratios, thereby increasing trust and confidence in the financial market. 

Last but not least, Basel III emphasizes the establishment of a robust risk governance framework, including the development of an appropriate compensation regime that integrates both business performance and long-term risk assessment results to ensure that short-term incentive assessments accurately reflect estimated long-term term risk costs.

                                                                          Source: The article was first published in Vietnam Investment Review, 21 February 2024