The Basel III framework, introduced in response to the 2008 Global Financial Crisis, aims to strengthen the regulation, supervision and risk management within the banking sector.
Its primary objectives are to enhance banks’ ability to absorb financial and economic stress shocks, improve risk management and increase transparency. The finalisation of Basel III — often referred to as “Basel III Endgame” — introduces comprehensive reforms that address previous shortcomings and set higher standards for capital adequacy.
The primary objective of the final Basel III reforms is to reduce excessive variability in risk-weighted assets (RWAs) and to restore confidence in the calculation of capital ratios. By refining the standardised approaches for credit, market and operational risks and introducing an output floor to limit the benefits banks can derive from internal models, these reforms aim to create a more level playing field and enhance the comparability of capital ratios across banks globally.
Implementation in Singapore
The adoption of Basel III rules across the Asia-Pacific region has been uneven, with varying timelines and degrees of implementation. Some jurisdictions have fully embraced the reforms, while others are progressing at a more measured pace due to domestic considerations. For instance, banks in Australia, China, Japan, Indonesia, Korea, New Zealand and Singapore have adopted parts or all of final Basel III rules.
Singapore has demonstrated a strong commitment to implementing Basel III reforms. The Monetary Authority of Singapore (MAS) has issued guidelines and notices to ensure that locally incorporated banks adhere to the enhanced capital adequacy requirements. Notably, MAS Notice 637 outlines the risk-based capital adequacy requirements for banks, transposing Basel III elements into local regulations. In June 2023, MAS published the implementation timeline for most of the final Basel III reforms effective July 1, 2024, outlining the phased adoption of the new capital adequacy requirements for banks incorporated in Singapore.
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Key components
The finalised Basel III framework introduces several critical components that banks must navigate:
Stricter use of internal models for credit risks: Banks can no longer use the advanced internal ratings-based (AIRB) approach for exposures to financial institutions and large corporates, as they cannot be modelled reliably given their low default rates. Banks are only allowed to use the foundation internal ratings-based (FIRB) and standardised approaches for these exposures. Internal models are not allowed for long-term equity investments and credit valuation adjustments (CVA). New floors are also imposed as inputs for internal models.
Output floor: This measure ensures that banks’ RWAs, as determined by internal models, do not fall below 72.5% of the RWAs computed using standardised approaches. The output floor is designed to mitigate the risk of underestimation of capital requirements through internal modelling.
Revised standardised approach for credit risks: Risk weights are more differentiated across various asset classes, including those in jurisdictions that do not allow external credit ratings.
Simplification of operational risk standards: A single standardised approach replaces four previous ones. The use of an internal model is no longer allowed.
Leverage ratio buffer: A leverage ratio buffer for global systemically important banks (GSIBs) has been introduced to further strengthen their resilience.
Fundamental review of the trading book (FRTB): This review incorporates more sophisticated risk measurement techniques that aim to align capital charges more closely to the actual risks banks are facing in their activities in capital markets. The rules define the boundary between trading and banking books, introduce new models to capture tail and non-modellable risks under the internal model approach and increase the risk sensitivity of the standardised approach.
Minimal impact
The fully phased final Basel III rules will likely have a minimal impact on Singapore banks’ capital requirements due to their limited reliance on AIRB models, which often result in smaller RWA than prescribed levels and local capital rules before final Basel III implementation are already stringent. Singaporean banks, including DBS Group Holdings, Oversea-Chinese Banking Corp (OCBC) and United Overseas Bank (UOB), are well-capitalised and have proactively managed their capital structures in anticipation of the final Basel III requirements.
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These lenders have historically maintained a conservative approach and use internal models that include more credit exposures under the standardised and FIRB approaches than the AIRB approach, resulting in lower risk weights. This means that the output floor’s impact may be less pronounced than that of global bank peers. As of 3Q2024, only 8% of Singapore banks’ total credit RWAs were modelled under AIRB models, significantly lower than similarly-rated Asian peers such as major Australian (over 50%) and Korean banks (over 40%).
Mitigating capital impact
To navigate the challenges posed by the final Basel III reforms, Singapore banks can employ several strategies:
Optimising accuracy of RWA calculations: Enhancing the accuracy of RWA calculations can lead to more efficient capital utilisation. This involves refining internal models and ensuring compliance with regulatory standards.
Adjusting business mix: Banks can shift focus towards fee-based services, such as wealth management and transactional banking, which do not attract additional capital charges. In 1H2024, wealth management businesses accounted for 28%–40% of total income for Singapore banks.
Repricing riskier loans: By increasing the pricing of higher-risk loans, banks can compensate for the additional capital required, thereby maintaining profitability.
Exiting unprofitable business segments: Discontinuing services to customer segments that are not economically viable under the new capital regime can improve overall financial health.
Impact on business models
While the final Basel III rules necessitate a re-evaluation of business models, Singapore banks are unlikely to make substantial changes to their business strategies or capital management. Their diversified portfolios allow them to offset RWA increases in certain asset classes with reductions in others. Credit risks are the largest factor in capital requirements for Singapore banks, as they make up the bulk of their total RWAs. Hence, even as the FRTB rules introduce more stringent capital requirements for market risk, potentially affecting banks’ ability to offer services like securities underwriting and market-making, given that trading books constitute a relatively low percentage of total RWAs (4%–9% as of 3Q2024) for Singapore banks, the impact may be limited.
Singapore banks continue to maintain robust capital buffers, with each holding at least $3 billion in excess Common Equity Tier 1 (CET1) capital above their management operating target ranges as of 3Q2024. This strong capital position provides a good cushion to absorb manageable increases in capital requirements under a fully phased-in final Basel III regime and reduces the immediate need for additional capital raising. The removal of internal ratings-based scaling factor of 1.06 under the final Basel III rules temporarily boosts the lenders’ capital ratios but will phase out over a five-year period for the output floor. As of 3Q2024, DBS’s and OCBC’s transitional CET1 ratio were 17.2% and UOB’s at 15.5%.
With ample excess capital, we expect Singapore banks to focus on capital management this year by adopting a balanced approach of dividends, strategic share buybacks and opportunistic borrowing to optimise their costly capital structures, especially in a gradual declining interest rate environment.
Significant milestone
The finalisation of Basel III rules represents a significant milestone in strengthening the global banking system’s resilience. Singapore banks, with their proactive capital optimisation measures, diversified business models as well as small-sized trading books, are well-positioned to navigate the challenges and opportunities presented by the new regulatory landscape. For global investors, the adherence to stringent capital requirements and the strategic adjustments undertaken by Singapore banks underscores their stability and commitment to sound risk management practices, bolstering their strong credit fundamentals and AA– ratings in the evolving financial environment.
Rena Kwok is a senior credit analyst (financials) at Bloomberg Intelligence
