Wednesday, August 13, 2014

Basel III Principles and Their Application to Banks in Oman

The Central Bank of Oman (“CBO”) has introduced the latest set of global regulatory standards known as Basel III to Omani banks. Basel III is a global, voluntary regulatory set of standards governing bank capital adequacy, stress testing and market liquidity risk. This third installment of the Basel Accord was developed in response to the deficiencies in financial regulation revealed in the aftermath of the global financial crisis in the late 2000s.


The first Basel Accord was introduced in 1988 following deliberations by 10 central banks from around the world when the Basel Committee on Banking Supervision (“BCBS”) in Basel, Switzerland, published a set of minimum capital requirements for banks, which was enforced by the then G-10 countries in 1992. Basel I was followed by a new set of rules comprising Basel II, published in 2004, which focussed mainly on how much capital banks need to set aside to guard against the types of financial and operational risks they face. Basel III seeks to further strengthen these measures and balance bank risk by requiring banks to hedge themselves against future financial crises and weather financial storms without requiring the assistance of central banks and governments. Basel III does not supersede either Basel I or II but builds on from Basel II and introduces additional reforms to improve and safeguard the regulation, supervision and risk management of the banking sector.

Basel III key principles

  1. Capital requirements: When banks lend money, they expose themselves to the risk of loans not being repaid so capital has to be set aside to cover that risk. The risk is not equal to the full amount of a bank’s lending portfolio so loans are weighted to arrive at the total amount of risk-weighted assets. Basel III requires banks to set aside a new ratio of 4.5% of common equity of risk-weighted assets, more than double Basel II’s 2% level, plus a new additional capital buffer of a further 2.5%. Banks whose capital falls within the buffer zone will face restrictions on paying dividends and discretionary bonuses, so the rule sets an effective floor of 7% or more, depending on the nature of activities and the type of bank. Where a bank grants a loan of OMR 200 million, for example, with risk-weighted assets of OMR 100 million, the bank must therefore set aside at least OMR 7 million under this rule.

  2. Leverage ratio: An underlying feature of the financial crisis was the build-up of excessive on- and off-balance sheet leverage in the banking system. In many cases, banks built up excessive leverage while maintaining strong risk-based capital ratios. Basel III seeks to restrict this by encouraging banks to take initiatives to reduce their balance sheets by placing a limit on the size of activities a bank can develop compared to its own capital. To achieve this, a minimum leverage ratio has been developed. The leverage ratio is calculated by dividing a bank’s Tier 1 capital (the core measure of a bank’s financial strength from a regulator’s point of view) by the bank’s average total consolidated assets. Banks have been set a target of maintaining a leverage ratio in excess of 3% under Basel III.

  3. Liquidity requirements: These are the third of the key Basel III reforms. In summary, Basel III has introduced two required liquidity ratios: (1) the Liquidity Cover Ratio (“LCR”) and (2) the Net Stable Funding Ratio (“NSFR”).

The objective of the LCR is to promote the short-term resilience of the liquidity risk profile of banks. It does this by ensuring that banks have an adequate stock of unencumbered high-quality liquid assets that can be converted easily and immediately in private markets into cash to meet their liquidity needs for a 30 calendar day liquidity stress scenario. The LCR is intended to improve the banking sector’s ability to absorb shocks arising from financial and economic stress, whatever the source, thus reducing the risk of spillover from the financial sector to the real economy.

The NSFR requires banks to maintain a stable funding profile in relation to the composition of their assets and off-balance sheet activities. A sustainable funding structure is intended to reduce the likelihood that disruptions to a bank’s regular sources of funding will erode its liquidity position in a way that would increase the risk of its failure and potentially lead to broader systemic stress. The NSFR seeks to limit overreliance on short-term wholesale funding, encourage better assessment of funding risk across all on- and off-balance sheet items, and promote funding stability.

Basel III in Oman

Oman is not one of the 27 national members of the BCBS; however, the CBO has called upon Omani banks to comply with Basel III standards and issued guidelines to implement this. The phasing in of the new rules began in January 2013 and will continue until December 2018, in keeping with the global timeline set out in Basel III for the implementation of its reforms.

While some commentators are wary of the hurdles that Basel III will pose in Oman, particularly with regards to how aspects of Islamic financing will fit neatly into Basel III measures, HE Hamood Sangour Al-Zadjali, Executive President of the CBO, gave an interview to the Oman Economic Review in April 2014, in which he discussed Oman’s compliance with international best banking practices and stated, as evidenced below, that the CBO is well ahead in the implementation of the Basel III framework.

“We have prescribed minimum regulatory capital for banks at 12 per cent of risk-weighted assets, much higher than that prescribed by the Basel norms. Moreover, the actual capital adequacy ratio is much higher at around 16 per cent. The CBO is well ahead in the implementation of Basel III framework, issued in November 2013. Some of the main features of these final guidelines prescribed by the CBO include: minimum common equity tier 1 ratio has been prescribed at seven per cent of risk weighted assets, while minimum Tier 1 capital ratio has been prescribed at nine per cent of risk weighted assets and the minimum total capital adequacy ratio has been prescribed at 12 per cent of risk weighted assets. All these norms … are in line with the international best practices prescribed by the Basel III.”