Effects of Basel II Accord on Qatar’s Banking Sector
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Chapter 1: Introduction
International banking is increasingly vital for every country in order to create an image for itself in the international finance market. Alongside, the increase in globalisation and the upsurge in outsourcing by multinational companies in the west have created a lot of opportunities for growth in the Middle East and Far Eastern countries. This apparently requires a strong internationally stable financial organization to conduct transactions across the globe without any errors (i.e.) 100% accuracy. This includes reliability and stability of the bank under extreme situations (like emergency for example), which is highly important to conduct international transactions. Also the potential to meet financial demands during crisis situations is a vital criterion that is considered while presenting themselves in the international market.
In addition to the globalisation, outsourcing and export/import growth, there is also a tremendous growth in cross-border finance among the countries in the Middle East and Far East. Along with all these factors the developing nations in the Middle East face a mandatory requirement of a sable international banking system in order to attract foreign investment.
The increase in cross border finance activity among the middle eastern countries is also a critical element to be considered for establishing a stable international bank within the nation in order to represent the country in the international finance market. The countries in the Middle East are actively participating in cross-border finance since the dawn of the 21st century. Being a producer of Oil which is a vital ingredient at all levels of life right from day-to-day driving up to power generation for the nation in order to run industries and serve domestic purposes, makes it critical for the nations in the Middle East to have a strong international banking system to conduct transactions across the globe accurately and effectively. Qatar is a growing nation in the Middle East with primary operations in oil and gas export as well increasing its potential in areas of development in technology focusing on IT and communication. The nation has efficient international operations and conducts financial transactions between western nations as well as with eastern nations. Since the take over of the government by H.H. Sheikh Hamad Bin Khalifa in 1995, the country is making tremendous progress in deploying its hydrocarbon resources in order to penetrate in the international market and present itself as a financially stable nation in the international market.
Further to the increase in the international operations by the countries in the Middle East and the Far East, the Bank for International Settlements developed a framework to co-ordinate the international financial operations as well as create a portfolio for the capital measurement and capital standards which every nation involving in international banking operations is expected to adopt in order to stabilise and put in order the international transactions between countries. The Basel II accord produced by Basel Committee on Banking Supervision aims at achieving International Convergence of Capital Measurement and Capital Standards. The arrangement aims to set a minimum standard to be met by its participating nations in order to achieve capital adequacy by the participating nations in the international market.
This report aims at analysing the effects of Basel II accord on Qatar’s banking sector. The objectives of this report are stated below:
- To analyse the Basel II accord and it’s framework for measuring capital adequacy in the nations participating in the international banking transaction.
- To investigate the banking sector of Qatar and the effect of Basel II accord on its international operations and capital adequacy.
- To analyse the effect of Basel II accord on the nation’s two major banks having international operations in Qatar namely, Qatar Industrial Development Bank (QIDB) and Commercial Bank of Qatar (CBQ) and to analyse the impact of Basel II Accord on the Banking Sector of Qatar.
The report comprises of the following chapters.
Chapter 1: Introduction
This chapter introduces the reader to the objectives of the report and presents a broad picture of the report to the reader.
Chapter 2: Overview of Basel II Accord
This chapter presents with an overview of the Basel II accord. The three pillars of Basel II accord namely Minimum Capital Requirements, Supervisory Review Process and Market Discipline are analysed in detail to provide the reader with a detailed understanding of the consent of Basel Committee on Banking Supervision.
Chapter 3: Implications and Critical Analysis of Basel II Accord
The literature review on the Basel II Accord in chapter 2 is followed by the critical analysis and its implications on nations (business and political) are presented to the reader before proceeding to present the overview of the Qatar Banking sector.
Chapter 4: Overview of Qatar and its Banking Sector
This chapter presents the reader with an overview of Qatar as a nation and its business operations in the International market. Alongside, the chapter analyses the country’s growth in the banking sector and its internationally active banks.
Chapter 5: Case Study
This chapter conducts a case study analysis on Qatar’s two internationally active banks namely Qatar Industrial Development Bank (QIDB) and Commercial Bank of Qatar (CBQ). The effect of Basel II accord on the banks along with an overview of the bank is presented to the reader. The data used to present the case study is primarily obtained from secondary sources like journals, reports and white papers. This is apparently due the fact that the analysis is conducted on a foreign nation as well as the data available from the secondary sources are also reliable as they are published by legitimate organizations and popular journals.
Chapter 6: Results and Discussions
The results of the case study analysis and discussions are carried out in this chapter. This chapter aims to present a clearer picture to the reader on the effects of the Basel II accord on the banks analysed.
Chapter 7: Conclusion and Recommendations
The conclusions derived from the case results and discussions on the case study and the overall conclusion on the effect of Basel I accord on the Qatar Banking Sector is presented in this chapter. Alongside, this chapter presents a few constructive recommendations based on the results and discussion on the case study.
Chapter 2: Overview of Basel II Accord
This chapter begins with an overview of the Bank for International Settlements followed by a detailed analysis of the Basel II accord. The Basel II committee is also analysed alongside in order to provide a deeper insight to the readers.
2.1 Bank for International Settlements Overview and it’s Operations
The Bank for International Settlements (Bank for International Settlements) is an international organization looking after international monetary and financial co-operation across the globe. This organization acts as the bank for all the central banks of countries participating in the international finance and banking.
The Bank for International Settlements profile states that the bank achieves the aforementioned statement through acting as
- A forum to promote discussion and facilitate decision-making processes among central banks and within the international financial and supervisory community.
- A centre for economic and monetary research
- A prime counter party for central banks in their financial transactions and
- Agent or trustee in connection with international financial operations.
Established in 17th Many 1930, it is the oldest financial organization at the international level.
The Bank for International Settlements has three major decision making bodies within the bank to achieve its mission. They are
The general meeting of member central banks
This meeting is held before the end of four months of the end of the banks annual financial year. The meeting addresses all the issues related to business and the member central banks gather to approve the annual financial statement released by the bank.
The Board of Directors
The board of directors comprise the central bank governors elected from various participating countries. They monitor the overall operation of the bank and take responsibility for actions to be taken and address issues related to disputes and other major international financial cross border problems.
The Management Committee
The management committee is the first line representative of the Bank for International Settlements and addresses the day-to-day activities of the bank. This committee primarily manages the monetary and financial co-operation services. The services include
Meetings: Apart from the Annual general meeting the Bank for International Settlements organizes meetings on a bimonthly basis. This meeting brings the member central banks together with the aim of monitoring the global economic and financial development and discusses issues on its policies in relation to the monetary and financial stability.
Committees and Secretariats
Bank for International Settlements has several committees to monitor specific problems and issues in the international finance and cross border loans. Alongside, several other committees and organizations focusing on international financial systems have their secretariats in the Bank for International Settlements and work closely with the bank in order to enhance the overall international banking and cross border finance.
Basel committee of the Bank for International Settlements is the committee that laid the specifications for capital measurement and capital standard of the central banks participating in the international banking.
Research and Statistics:
In order to support its meetings and the activities of the organization’s Basel based committees the Bank for International Settlements carries out regular research on economic, monetary, financial and legal areas of the international banking and cross border finance.
Investment services for central banks:
Bank for International Settlements also provides security, liquidity and return for its central bank members. The three primary points with respect to this identified by the organization are
- To provide security, the Bank has built up a sizeable equity capital and ample reserves. It pursues an investment strategy focused on combining diversification benefits with intensive credit and market risk analysis.
- To ensure liquidity, the Bank stands ready to repurchase its tradable instruments at little cost to its customers and thus respond quickly and flexibly to their needs.
- The BIS offers an attractive and competitive return on the funds deposited by central banks and international organisations
The Bank for International Settlements focuses on serving the financial needs of central banks of the member countries. Alongside, it also acts as a banker managing the funds for numerous international financial institutions.
2.2: Basel committee Overview
The Basel committee was established the member central banks of the Bank for International Settlements in order to create a standard for the international banking and capital framework for crass border finance and lending. The committee was initially set up in 1970 and meets regularly four times a year to discuss the progress in international banking and address issues related to business in this context.
The member nations of the committee include Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, United Kingdom and United States. The country’s central bank and financial institutions that are not active in banking commercially but monitor the financial operations of the nation both at national and international levels represent the nations. The committee does no possess any authority over its member nations banking systems and the decisions of the committee are never intended to have a legal force on its member nations.
The Central bank governors of the Group ten countries endorse the committee’s major initiatives. Also the committee reports to the group ten countries central bank governors. The committee first proposed he capital measurement system in 1988 commonly referred to as ‘Basel Capital Accord’. The committee aims in supervising the international banking operations of the nations across the globe. The decisions of the committee endorsed by the group ten countries address various financial issues in the international market outside the groups as well.
The major aim of the committee is the ‘close the gaps in international supervisory coverage’ and to ensure that no foreign banking systems escapes the supervision in order to establish a harmony among the member nations of the Bank for International Settlements as well as in the international market.
The committee has promoted supervisory standards in the past few years. Some of its major milestones include the following
1997: Cover Principles for effective banking supervision
1999: Core Principles methodology
The committee also presented the Basel II accord with revision on international capital framework. This aims to standardise the capital framework of every bank participating in the international banking as well as sets slabs for minimum capital holdings to be met by the banks in order to qualify for international operations.
The committee has numerous subgroups to perform specific tasks of the committee in order to achieve the overall motto of the committee. They are listed below
- Accord Implementation Group
- Accounting Task Force
- Capital Group
- Capital Task Force
- Core Principles Liaison Group (with 16 non-G10 countries)
- Cross-Border Banking Group
- Electronic Banking Group
- Joint Forum (with IAIS and IOSCO)
- Joint IOSCO - BCBS Working Group on Trading Book
- Research Task Force
- Risk Management Group
- Securitisation Group
- Transparency Group
The next section provides a detailed analysis of the Basel II accord and its various implications on international banking is discussed in chapter 3.
2.3 The Basel II Accord
The Basel II accord was released in June 2004 further to the release of the Basel Accord in 2003. The Basel II is a revised edition of the initial Basel capital accord. It is a framework designed to derive the capital holdings of internationally active banks to meet the international standards and sets a minimum level of capital holding which is a primary criteria for the banks. The Basel II framework is aimed to be applied on a consolidated basis over internationally active banks in order to preserve the integrity of capital in the banks with subsidiaries. Also the framework eliminates the double gearing through this approach.
The Basel II accord’s framework is also applied on a fully consolidated basis on any parent holding company which acts as a parent entity within a banking group in order to capture the risk on a consolidated basis without missing any element that contributes considerably to the risk of the overall banking system.
Alongside, the framework is also applicable to all internationally active banks at every tier of the banking group.
Apart from the aforementioned statements one of the principal objectives of the Basel II Accord is to protect the interest of the depositors essentially to ensure that capital recognised capital adequacy measures is readily available for the depositors. Apparently, these measures are aimed to establish a common platform for international banking and cross border finance across the globe.
The scope of application extends to the following segments of the international banking and finance entities.
- Banking, securities and other financial subsidiaries
- Significant minority investments in banking securities
- Insurance entities
- Significant investment in commercial entities.
- Deduction of investment pursuant to this part
The aforementioned entities are obtained from the Basel Committee report on International Convergence of Capital Measurement and Capital Standards, published in June 2004. The Basel II accord overview is based on this report. The illustration in the fig 1 gives a clear picture of the overall scope of application of the Basel II accord.
The Basel II accord is split into three pillars.
The first Pillar: Minimum Capital Requirements
This is the very important pillar of the Basel II Accord. This pillar has very clear definitions of the Accord’s application on the credit risks and operational risk along with the Trading Book issues that are vital for international banking establishment.
The layout in fig 2 reproduced from the Basel II report provides the inner picture of the First Pillar.
The following subsections provide a detailed analysis on the elements shown in fig 2.
2.4: The First Pillar
The First pillar lays down the minimum capital requirements that every internationally active bank should incorporate. It is split into the following subsection.
2.4.1: Calculation of Minimum capital requirements
The minimum capital requirement is calculated as a measure of the capital ration. The capital ratio in turn is calculated using the regulatory capital and risk-weighted assets. The requirement of this criterion is that the capital ration must be a minimum of 8% or more in order to be eligible for the international activities. Also, in case of a two tier system the capital in tier 2 must not be greater than the tier 1 capital (i.e.) the tier 2 capital can be a maximum of 100% of the tier 1 capital. The capital is accounted from the following sources
Regulatory capital: The minimum accounting capital requirements for the financial institution encompasses the regulatory capital. The Basel II accord has withdrawn the provision to include general provisions in tire 2 capital, which was in effect in the 1988 Accord under the Internal Ratings-Based (IRB) approach. Furthermore the accord has lain down that the banks using the Internal Ratings Based approach to their other assets must compare the amount of total eligible provision with the total expected losses amount to the bank. This eventually increases the capital holding of the bank in order to meet the criteria.
Risk Weighted Assets: The Basel II Accord calculates the total risk-weighted assets by multiplying the capital requirement for market risk and operational risk by the reciprocal of the minimum capital ratio of 8% and adding the resulting value to the sum of risk weighted assets for credit risk. Even though this is subject to review the approach lays enormous burden on the bank to increase its minimum capital holdings. Apparently the Basel II Accord is aiming to establish that the internationally active banks must have enough capital to meet its short comings without depending on loans and cross border finance to address its immediate requirements and short comings. The idea though being novel is very intense for the banks to maintain the required minimum capital.
Transitional Arrangements: The Accord has also stated that the banks following the Internal Ratings-Based approach or the Advanced Measurements Approach (AMA) that there will be a capital floor after the implementation of the Basel II framework. The adjustment factors used in both the internal ratings-based approach and the advanced measurements approach for calculating the capital floor as per the definition of the Basel II framework is shown in fig 3 below.
2.4.2: Credit Risk-The Standardised Approach
Under this method the Basel committee provides the internationally active banks a choice for calculating their capital requirements for credit risk. The first approach is the standardised method of measuring the credit risk through support from external credit assessments. This method is approved by the Basel committee while the other method is yet to explicitly approved by the committee. Under the alternate method of calculating the credit risk, the bank supervisor can allow banks to use their internal rating systems for calculating the credit risk.
Under both the methodologies one should not oversee the fact that the Basel committee is very keen in assessing the credit risk on the capital holdings of the internationally active banks. Even though this is appreciated, the rules are very stringent making it very difficult for the banks for adopt easily.
2.4.3 Credit Risk- Internal Ratings Based Approach
The Basel II committee has given supervisory approval for banks to use the Internal Ratings-Based approach to determine their capital requirement for a given exposure subject to certain minimum conditions and disclosure requirements. The risk components considered include
- Measures of the probability of default (PD),
- Loss given default (LGD),
- The exposure at default (EAD),
- Effective maturity (M)
The Basel II accord states that “The Internal Ratings Based Approach is based on the measure of unexpected loses (UL) and Expected Loses (EL).
Under the Internal Ratings Based Approach, the committee expects the bank to categories their exposures in order to identify the different underlying risk characteristics. The categories include corporate, sovereign, bank, retail and equity. These are identified as the corporate asset classes and the approach further expects the bank to identify the subclasses associated with the asset classes in order to measure the credit risk associated with the exposure. The detailed analysis of every corporate class and its associated subclasses is beyond the scope of this report.
In essence the Internal Ratings Based Approach gives the bank more liberty to calculate its credit-risk on the minimum capital requirement for a given exposure. But the producers laid by the Basel II Accord is very tedious to adopt and implement for every corporate class exposure and identifying the subclasses associated.
2.4.4: Credit Risk- Securitisation Framework
The Basel Committee in its revised accord, has made it mandatory for the banks to apply the Securitisation Framework for determining regulatory capital requirements on exposure arising from traditional and synthetic Securitisation or similar structures that contain features common to both. The Basel II accord also states that the capital treatment of the Securitisation exposure must be determined on the basis of the economic substance rather than the legal form of the structure. It is apparent that the securities can be structured in many different ways and the committee has approved the use of either the traditional Securitisation or the synthetic Securitisation framework. Also the Basel II accord expects the supervisor to look at the economic substance of transaction in order to determine whether it should be subject to Securitisation framework or not. This gives the discretionary power to the supervisor to decide on a specific transaction whether to include it in the framework or to eliminate it from the framework towards determining the regulatory capital framework. The traditional Securitisation and the synthetic Securitisation framework are discussed below.
The Basel II Accord defines the traditional framework as “a structure where the cash flow from an underlying pool of exposures is used to service at least two different stratified risk positions or tranches reflecting different degrees of credit risk”. The advantage with this approach is that the payment to the investors is based on the performance of the specified underlying exposures rather than a derivation from an obligation of the entity originating those exposures.
“A synthetic Securitisation is a structure with at least two different stratified risk positions or tranches that reflect different degrees of credit risk where credit risk of an underlying pool of exposures is transferred, in whole or in part, through the use of funded (e.g. credit-linked notes) or un-funded (e.g. credit default swaps) credit derivatives or guarantees that serve to hedge the credit risk of the portfolio”.
This approach leaves the return to the investors in the hands of the performance of the underlying pool. Apparently, the risk associated is higher since the performance can be affected by numerous causes.
From the above-mentioned approaches the Basel II accord’s stand for evaluating the capital and minimum capital requirements are evident.
2.4.5: Operational Risk
The operational risk is defined by the Basel Committee as the risk associated with the loss resulting from inadequate or failed internal processes, people, systems or external events. This includes the legal risk with the exclusion of strategic and reputational risk.
The Basel II Accord has approved three methods for calculating the operational risk and risk sensitivity with the implications on minimum capital requirements. They are:
(i) The Basic indicator approach, (ii) the Standardised Approach and (iii) Advanced Measurement Approach.
Basic Indicator Approach:
In this case the banks should hold capital for the operational risk equal to the average over the past three years of a fixed percentage. This is expressed as a formula below
KBIA = [Σ (GI1…n x α)]/n
KBIA = the capital charge under the Basic Indicator Approach
GI = annual gross income, where positive, over the previous three years
n = number of the previous three years for which gross income is positive
α = 15%, which is set by the Committee, relating the industry wide level of required capital to the industry wide level of the indicator. This formula is obtained from the Basel II accord for the purpose of reader understanding.
The standardised approach divides the bank’s activities into eight-business lines namely corporate finance, trading & sales, retail banking, commercial banking, payment & settlement, agency services, asset management, and retail brokerage.
The likelihood of operational risk exposure is calculated from the gross income associated with each business line that serves as an indicator for the scale of business operations by the bank in that specific area of business or business line.
This approach is very clumsy since the gross income associated with the business line varies due to numerous reasons both internal and external.
Advanced Measurement Approach:
The Advanced Measurement Approach equates the regulatory capital requirement with the risk measure generated by the bank’s internal operational risk measurement system using quantitative and qualitative criteria. The banks can use this method only after the approval by the Committee.
The Basel II Accord sets the approach for the banks based on their international activity and significant operational risk exposures. Also, when a bank agrees to use a more sophisticated method, it cannot revert back to the easier method without approval from the supervisor. This eventually increases the burden on the banks to choose a sophisticated method.
2.4.6: Trading Book Issues
The final segment of the first pillar is the trading book.
Basel Committee defines the trading book as a container of both the financial instruments and commodities held either with trading intent or in order to hedge other elements of the trading book. The trading book forms a vital element for the bank since it is the record of the bank’s financial instruments as well as commodities.
The Basel II Accord identifies four key principles for the supervisory process. They are listed below.
The basic requirements for the eligibility to trading book capital treatment put forth by the Basel II Accord are as follows
- Clearly documented trading strategy for the position/instrument or portfolios, approved by senior management (which would include expected holding horizon).
- Clearly defined policies and procedures for the active management of the position
- Clearly defined policy and procedures to monitor the positions against the bank’s trading strategy including the monitoring of turnover and stale positions in the bank’s trading book
2.3: The Second Pillar- Supervisory Review Process
Basel committee was initially set up for the supervising the internationally active banks and produce a common platform for the smooth transactions and cross border finance. The Basel II Accord has established Supervisory Process as one of the three pillars in order to emphasise its stand on supervisory process.
The importance of supervisory process is described below.
2.3.1: Importance of Supervisory Process
The supervisory review process of the Basel II Accord aims not only to ensure that banks have adequate capital to support all the risks in their business but also intends to encourage the banks to develop and use better risk management techniques in monitoring and managing risks. Alongside, the supervisory process by developing internal capital assessment process and setting capital targets that are commensurate with the bank’s risk profile recognises the importance for bank management in order to improve the atmosphere in the international banking and cross border finance.
The Supervisory process evaluates the relationship between the amount of capital held by the bank against the risk, strength and effectiveness of the bank’s risk management eventually guiding the bank and supervising its activities in order to improve the performance of the banks in the international business market and cross border finance.
2.3.2 Four Key Principles of the supervisory review
The four key principles identified by the Basel II Accord on the supervisory process is listed below. These principles emphasise on the committee’s focus on supervision and its aim to maintain harmony in the international banking and cross border finance.
Principle 1: Banks should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels.
Principle 2: Supervisors should review and evaluate banks’ internal capital adequacy assessments and strategies, as well as their ability to monitor and ensure their compliance with regulatory capital ratios. Supervisors should take appropriate supervisory action if they are not satisfied with the result of this process.
Principle 3: Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require banks to hold capital in excess of the minimum.
Principle 4: Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of a particular bank and should require rapid remedial action if capital is not maintained or restored.
2.3.3: Issues to be addressed
There are two specific issues to be addressed by the Supervisory-Review Process. They are
Interest Rate Risk in the Banking book:
Since it is clear that the Basel Committee’s primary focus is on identifying and preventing risk in the international banking, the committee has perceived that the interest rate risk in the banking book is a potential risk that commends support from the capital. The interest rate risk was initially identified as a potential risk under pillar one of the accord but after through analysis of the internationally active banks and having perceived the heterogeneity among them, the committee has considered the interest rate risk in the banking book under pillar 2.
The Basel II Accord considers credit risk to be addressed by the supervisory review process in order to monitor the credit risk and the implications on the regulatory capital of the bank. The four different approaches listed by the Basel Committee are listed below.
Stress tests Under the IRB approaches
Definition of Default
Residual Risk and
Credit Concentration risk
The aforementioned are not explained in detail due the word limit restrictions of this report. The Basel II Accord provides a clear description.
The Basel I Accord also expects the supervisory process to monitor and review the operational risk associated with the bank. This is obviously because of the fact that the gross income used is a proxy for the scale of operational risk exposure of a bank and in some cases can underestimate the need for capital for operational risk. Thus the Basel Committee has ensured that the operational risk is under the supervisory process in order to establish a balance between the operational risk and the capital employed by the banks.
2.3.4: Supervisory Process for Securitisation
Furthermore the supervisory process is applied for the Securitisation under the pillar 1 of the accord. Further to the statement that the banks should take account of the economic substance of transactions while determining the capital adequacy, the need for supervision to ensure that the banks have properly adopted this while deriving the Securitisation is inevitable. Thus the Basel Committee has brought the supervision of the Securitisation process as an essential element in Pillar 2 of the Basel II Accord.
The supervisory process for the Securitisation focuses on
- Significance of Risk transfer
- Market innovations
- Provision for implicit support
- Residual risks
- Call provisions and
- Early amortisation
These factors make the supervisory process a critical element of the Basel II accord and hence it is considered as the Pillar 2 of the framework.
2.4: Third Pillar- Market Discipline
The third pillar is primarily aimed to complement the Minimum Capital Requirements (Pillar 1) and supervisory Review Process (Pillar 2) of the Basel II Accord. The Basel II Accord states that “ The Committee aims to encourage market discipline by developing a set of disclosure requirements which will allow market participants to assess key pieces of information on the scope of application, capital, risk exposures, risk assessment processes, and hence the capital adequacy of the institution”.
Apparently the banks that are internationally active are expected to disclose their transactions and activities to the Supervisory process and prove that they satisfy the minimum capital requirements (Pillar1) of the Basel II Accord. Alongside the committee expects the banks to disclose the right information required by the supervisors to conduct the supervisory process and also to assess the bank’s assets and regulatory capital. The Committee expects the internationally active banks to extend full co-operation to the supervisors and the Basel Committee through disclosing the right information in order to make the decision on the banks’ capital and its ability to meet the risks associated with its business and operations.
Te banks are expected to have formal disclosure policies approved by the board of directors addressing the bank’s approach in order to determine those disclosures the bank is prepared to make and the internal controls over the disclosure policies. These are put into practise only after the formal approval of the Basel committee.
Even though the supervisors have different powers at their disposal to obtain the required disclosure, the Basel Committee aims to achieve a safe and efficient banking environment through the market discipline (Pillar 3) of the Basel II Accord.
The disclosure requirements of the market discipline is extensive and covers all the areas of the disclosure requirements for efficiently deploying the minimum capital requirements (Pillar 1) and Supervisory Review Process (Pillar 2).
The areas covered in the disclosure requirements under the market discipline include the capital structure, Credit Risks and the operational risks addressed by the bank to determine their regulatory capital and address the Pillar 1 and Pillar 2 of the Basel II Accord.
From the above sections it is evident that the Basel committee is keen in achieving an efficient supervisory control over the internationally active banks and to establish a standard international banking environment for conducting the business process efficiently and effectively across the globe.
The next chapter discuses the implications of the Basel II Accord and presents a critical analysis of the three Pillars in its literature. The aim of the chapter 3 is to provide the real world situation and the reaction of banks and financial organizations to the Basel II Accord.
Chapter 3: Implications and Critical Analysis of Basel II Accord
Even though the aim of Basel II Accord is to build a solid foundation of prudent capital regulation, supervision and market discipline ultimately enhancing risk management financial stability, the approach of the Accord is very crude and complex as identified by numerous authorities in finance.
Issues on regulation and risk management:
The Basel I Accord’s primary goal is to achieve regulation on the internationally active banks. Avinash Persuad (2003) has identified the critical elements for the proper regulation of the banks as
The one important fact about any bank is that the lending of the bank is always more than the capital it holds. When it comes to the internationally active banks, the situation is even bigger and critical since the lending of the internationally active banks and its cross border finance are invariably greater than the capital they hold. Apparently, the Basel II Accord states that the minimum capital held by the banks must be able to meet their risks and liabilities. This means that either the banks are expected to hold more capital or roll back their lending across the border and restrict their international operations in order to meet the Basel II Accord without grossly increasing their capital holding. When it comes to the issue of Middle East the countries are rapidly growing due their invaluable oil resources and their growth in international banking is increasing as well. Qatar the country under consideration in this report is actively lending money to many African countries and has become increasingly active in the international banking and cross border finance. Apparently, the country’s banks now need to either increase their capital holding to meet the minimum capital requirement of the Basel II Accord or to roll back their transactions if they choose not to increase their capital holdings. In both the cases the banks face a critical situation since their growth is greatly affected by the accord’s minimum capital requirements.
Avinash Persuad (2003) states that the banking sector is dependant on information and that the knowledge of the customer is the key for a successful banking system. In the international scenario the knowledge of the customer and his/her operations is more vital than the customer’s credit history. Knowing the customer’s market, the potential for his/her business and the ability to forecast accurately the customers business in the future are the vital elements to conduct cross border finance especially while lending money to a foreign entity. The fact that credit risk analysis, credit history and the risk management are efficient in helping the governor make a decision on a specific loan can be appreciated but the knowledge of customer and analysis of his/her potential is more vital for decision making. This will eventually increase the risk held by the bank ultimately pushing the bank to hold more capital in order to meet its risks. The argument makes it clear that the Basel II Accord is purely based on the technical calculations and formulae of the risk management and credit risk analysis not giving importance to the knowledge of the customer which is incorrect for an efficient banking system.
It is evident that the bigger a bank is the more is its systemic risks since its lending will be higher than its capital holdings invariably. The three major factors that are critical for efficient regulatory management are
- Place additional regulatory costs on the big systemically important banks i.e. the internationally banks in the developing nations should not be herder by the regulations and minimum capital expectations as much as those banks from the developed nations.
- Encourage banks to give importance to accurate information both local and international rather than conducting risk analysis with a bunch of formulae.
- The risk management should use external measures of risk without placing importance to the market trend, market price and the market behaviour. This is required in order to create a more global approach to the international banking and cross border finance.
Form the study of Basel II Accord in chapter 2 we can immediately infer that the Basel II accord does exactly the opposite of the aforementioned statements. This eventually increases the burden on the banks as well as makes the accord more and more unpopular among the internationally active banks in the developing countries from the Middle East and Far East.
Complex Regulatory approach:
The regulatory approach of the Basel II Accord is very complex and cannot be adopted easily by many internationally active banks in the developing nations. The procedure is aimed to achieve a general regulatory perspective on the banks focusing more on bigger banks from the west. Apparently those from the developing nations face the trouble of gaining more knowledge of the procedure and comprehending it to their banking system in order to achieve the international standards approval fro the committee. The regulatory procedures are very hard to incorporate in the banks from the developing countries apart from the cost issues that need to be considered as well. The costs associated with incorporating the complex regulatory procedures are also high. This is discussed in the next section. The Basle II Accord is very complex in the areas where it has to be simple making it look like a barrier instead of a guiding force to the internationally active banks.
Harald Beninck (2004) says, “Although the proposed accord is an important improvement on Basel I, it fails to create a supervisory regime that embodies a credible and strong market discipline”. This obviously due the highly complex and crude regulatory policies of the Basel II accord along with the stringent measure in the risk assessment and market regulation. Alongside there are strong arguments that there is no sound basis for assessing the capital impact in the Basel II Accord. Apparently, this makes it very difficult for banks in the developing countries of the Middle East and Far East to incorporate Basel II and proceed to the international business market efficiently participating cross border finance.
Approach to Risk Evaluation:
The Basel II approach to risk evaluation is very hard to implement even though it aims to cover various elements of the credit risks and the operational risks associated with the bank’s business. The committee’s proposal to encourage the banks to maintain internal ratings may sound to b an incentive but the ratings will be accepted only subject to he approval of the committee. The minimum capital requirement of the Basel II Accord considers various aspects of the risks and the more the risk associated with a bank’s business the more it has to maintain its capital in order to meet the risks.
The Basel II Accord’s approach is through a recalculation of the unexpected versus expected losses associated with the bank’s business. This eventually increases the minimum capital holdings slab of the banks that provides more risky loans like credit cards where the portfolio yield more than covers the risk. The calculation of the risk weights using the Internal Ratings-Based method is not effective as it increases the overall assessed value of the risk eventually increasing the capital requirements for the bank. The banks from the developing countries could not afford to adopt this method merely because of the reason that the ratings increase the minimum capital to be held. Along with these issues the ratings are also more stringent on the level of risk associated with the loan through mere calculations without giving importance to the information and the potential of the customer. Apparently these issues are very critical for a bank in the developing country as the risk associated with its business both national and international will be high through the calculations of the Internal Ratings-Based Method. The basic policy to maintain superior information about the customer both in the country and in the international operations by a bank becomes useless through the application of the Internal Ratings Based approach since the calculation is more focused towards the situation and circumstances apart from using the actual information in the nation. Thus the Internal Ratings-Based approach is not a valuable one to be used by banks in the developing countries to assess their risk and eventually calculate their regulatory capital.
Increased Operating Costs:
The use of the complex methodologies and techniques in the evaluation of the risk as well as in deriving the regulatory capital means that the costs associated i.e. the general operating costs for the bank will increase considerably. The banks that are already deploying the Internal Ratings Based method and other techniques are those who are well established in the international banking for years and are market leaders in the international finance market. Those banks that are small or developing cannot incorporate these methodologies without initially restructuring their set up itself. Apart from this the banks will incur huge costs to commission the personnel to implement the policies and the new methodologies in order to meet the standards laid by the Basel II Accord. This apparently increase the burden of costs and initial investment from the banks in their restructuring and implementation of new methodologies in order to meet the Basel II Accord’s norms.
Apart from the costs involved in the implementation of methodologies the supervisory regulation also comes with a heavy cost for the banks to adopt and maintain the process as well as the personnel. This not only means the expenses for the new costing methods but also the cost of maintaining the profound policies and system management in order to meet the supervisory process specifications which is a very high value for the developing banks.
Burden of Control:
The Basel II Accord places most of the responsibilities on the supervisory authorities to control the banks. This eventually increases the likelihood for error and inefficiency when the supervising authority is overloaded with the bank’s information or the activities of the bank is overwhelming to comprehend in order to create the proper regulatory structure. Apart from the trouble of in accuracy, the supervisors are expected to work closely with the banks while developing and upgrading their risk scoring models.
The Basel II Accord by allowing the supervisor to work closely with the banks aims to eliminate the information asymmetry between the banks and the supervisors in order to ease the process of assessing the banks to derive on the regulatory capital with respect to the minimum capital requirements of the Pillar 1 of Basel II Accord. Thus the supervisors will eventually find it difficult to comprehend the information of the banks credit risk models since the banks themselves have the problem in translating their own ratings into probabilities of default. Harald Bennick (2004) identifies the reason as “the lack of data over a longer time horizon capturing the credit risk related to the full economic cycle of 10-15 years and due to the large variety of internal ratings systems” in his article on Basel II for Financial Times.
Alongside, it is again difficult for the supervisors to cheek the validity of the estimates provided by the banks just because it is difficult to comprehend the information on credit risk and the derivatives over the years. Apparently the aim of Basel II to achieve effective supervision over internationally active banks is not realised due to this reason.
The increased supervisory process also leads to a lot of moral hazards. The disclosure principles and the requirements established in the Basel II Accord are very high and most of the banks in the middles east will not accept to comply with these requirements due to their nation’s policies and principles which are strongly backed by their religious beliefs in morality and authority in trading.
Market Discipline Issues
The implication of the Market discipline and the strict rules for policies on disclosure of the risks and capital holdings to the supervisory process apparently means that the banks feel intimidated by the Basel II Accord and that the basic trust on the banks by the Basel committee is indeed under question. Apart from this moral issue the implementation of market discipline will increase the potential underestimation of the credit risk and the degree of regulatory capture is also limited since the Basel II Accord does not provide a strong mechanism for such processes and discipline issues. Eventually the credit rating and risk analysis to derive the minimum capital requirement will not be accurate thus leading the committee to make unsophisticated decisions on the bank’s supervision and its regulatory capital holding.
Also one should consider the fact that the information about the potential credit losses is not going to be a critical issues as long as the depositors and other creditors are insured or implicitly expected to be bailed out under the worst-case scenario. This is not considered in the Basel II Accord and the risk of such insured credit losses are also taken into account in order to calculate the regulatory capital for the banks. The policy of information disclosure and transparency will generate strong market discipline only when the information is analysed by professional investors those who have maximum incentives to use this information in order to make their decisions.
Apparently form the above arguments it is clear that the Basel II Accord has over emphasized the market discipline procedures in the view of creating a robust and more concrete supervisory control over internationally active banks. Apart from these issues, the banks from various nations in the Middle East are guarded by strong cultural policies and these policies act tangentially to the market discipline procedures laid by Basel II Accord. This eventually complicates the market discipline issues in the Basel II Accord.
Subordinated Debt Issues:
The issue of subordinated debt is another critical factor in the Basel II Accord. Under the Basel II Accord the large banks are expected to have a certain amount of subordinated debt. The current issue is that the subordinated debt must be declared as credibly uninsured, which apparently leaves the banks with more credit risk under the Internal ratings, based calculations. Eventually the regulatory capital amount will rise drastically under the criteria in the Pillar 1 of the Basel II Accord. These arguments lead the banks to conclude that the capital impact of Basel II is rather premature and thus not effective in supervising the internationally active banks and mostly misleading the decision makers.
The quantitative Impact Study conducted by USA on the Base II Accord was also incomplete in addressing these issues. Also Harald Bennick (2004) says that the Basel II Accord is incomplete in assessing the capital impact of the internationally active banks and in supervisory process thus producing a lot of shortcomings in the basic approach of the Basel II accord itself.
Uneven approach to the supervisory process:
Apart from the issues addressed above, USA has declared that it is going to implement the Basel II Accord to only twenty major banks in its country and the rest of the banks in the country are expected to be in the Basel I framework. This eventually creates an uneven ground for the banks in the international market since USA is a major player from the west in the international finance and cross border finance. Since the banks from the western countries are already following most of the ratings and framework policies of the Basel II Accord, the calculations in under the internal ratings base approach may significantly reduce the regulatory capital for these banks whilst in the Middle East and Far East where the countries re yet o adopt to the Basel I accord itself this is eventually going to be a bumpy ride especially for the banks in the Middle East.
From the above analysis of the Basel II Accord it is evident that the banks from the Middle East face a potential threat of reducing their transactions in the cross border finance as well as there is a need for them to increase their regulatory capital in order to meet the Basel II Accord’s requirements. This eventually increases the operating costs and also lays a barrier to the growth of the banks if they do not accommodate themselves to the changes quickly.
Alongside, the cultural and political policies of the countries in the Middle East prevents the banks from disclosing most of the information to the supervisory process and especially to meet the specifications laid by the market discipline (Pillar 3) of the Basel I Accord.
Chapter 4: Overview of Qatar and its Banking Sector
This chapter intends to present an analysis of Qatar right from its history, to its present development and its international perspective. Then the chapter provides an analysis of the Banking sector of Qatar in order to create a more profound understanding on Qatar an its banking sector. This is necessary before proceeding to the case study analysis of the tow major banks in Qatar in chapter 5.
4.1 Overview of Qatar:
Qatar is a growing nation in the Middle East through efficiently deploying its oil resources in the international market. The history of Qatar dates from the 5th or 6th Centuries BC. The country’s religion is considered as Islam. Qatar was under the British rule till 1971. In 1971 Britain decided to withdraw from the gulf and since then Qatar has become an independent nation. The country was approved an Arab Nation following its independence and Arabic was declared as the National Language.
Oil export was the major business in the nation and in 1974 the Qatar General Petroleum Corporation took control of all oil operations in the nation. Since then the country has made rapid progress in its economy raising into a rich nation and performing international banking and cross border finance in the recent years.
In 1995 the nation saw another major change, which is the take over of the Government by His Highness Sheikh Hamad bin Khalifa Al Thani from his father. The accession of the government by His Highness Sheikh Hamad bin Khalifa Al Thani resulted in tremendous growth of the nation not only in oil but also in media, communications and in banking sector. The country has many internationally active banks both national and international conducting cross border finance in the nation.
4.2: Economy of Qatar
Even though oil contributes the major percentage of the country’s Gross domestic product, Qatar also has business operations in petrochemicals, fertilizers and steel reinforcing bar manufacturing. Oil contributes to 30% of the Gross Domestic Product of the nation. The other segments of business are primarily dependant on the oil industries.
The country generates 80% of its export earnings from oil and oil based products export. Statistics show that the oil reserves in Qatar is around 3.7 billion barrels which will enable to country to provide continuous output and sustained growth for the next 23 years approximately. Apparently, the oil export is primarily to the western countries as well as to the east. It is understood that oil forms a major source of energy in the world and an oil rich nation eventually is naturally richer than a country with immense gold reserves.
Since the independence in 1971 Qatar has been actively exporting oil and the international operations have grown after the take over by His Highness Sheikh Hamad bin Khalifa Al Thani in 1995. The new ruler has not only improved the oil export business but also concentrated in the country’s growth in other areas like communications and media. The Al Jazeera the TV channel in the Middle East launched by Qatar is a major development in the field of communications and media.
The nation is also concentrating on various other industries like petrochemicals and steel manufacture.
The country’s population is mainly concentrated on the industry based work mainly oil and refineries. More than 90% of the population is involved in the industrial work and services while a meagre portion is concentrating on agriculture. Agriculture is not the major source of income but still the country imports most of the food products and pioneers in export of dates.
The country imports mainly machineries & transport equipments, chemicals and food products while its exports include Petroleum products, fertilizers and steel. The country has developed drastically in the field of banking and has many international operations and actively involves in cross border finance.
4.3: Qatar’s Banking Sector
The Qatar monetary Agency (QMA) was set up in 1973 with a mandate to carry out the functions of a central bank in the nation. The Qatar Monetary Agency supervises all the operations in the nation and controls the banks in the country. Both the national and the international banks having operations in Qatar are expected to abide by the rules and regulations of the Qatar Monetary Agency. The Qatar Monetary Agency is also in charge of insurance, circulation and withdrawal of currency, maintenance of the stability of currency both at national and international levels and provides the guarantees that the Qatar Riyal (QR) is freely convertible in the international market.
With the increase in the export and import operations in Qatar the banking sector has also seen tremendous growth in Qatar. The country has many international banks like HSBC and Standard Chartered having operations in Qatar. Alongside, many of the nationalised banks of Qatar have also increased their operations at international level and have been actively involving in cross border finance. The banks internationally active in Qatar include Commercial Bank of Qatar (CBQ) and Qatar Central Bank (QCB). A case study analysis on these banks is presented in the next chapter.
The 2002 annual banking sector review shows that the banking sector of Qatar has been growing steadily for five years. The banking sector review of Qatar also gives us evidence that the banking sector of Qatar has made progress in international as well as national operations.
The increase in the assets by 11.7% in 2002 (Qatari Riyal 6.6 billion) to QATARI RIYAL 63.5 billion in 2002 is a landmark achievement for a developing nation like Qatar. Furthermore, the assets of the Qatar banks alone have increased by 11.7% (Qatari Riyal 5.9 billion) to Qatari Riyal 56.6 billion which proves the fact that the country is seriously concentrating in the growth of the banking sector in Qatar so as to establish a strong foreign trading system.
The law in Qatar states that in order to start a bank in Qatar, the organizations must have a minimum paid up capital of QR 5 million. If a subsidiary of a foreign bank is to be established in Qatar the bank must have QR 5 million of working Capital in Qatar for its operations.
There are fourteen national banks in Qatar of which six are Qatari National Banks whiled the others toe Arab banks and six foreign banks in the country. The list of all the banks in the country is given below.
There are six national banks in Qatar:
The Commercial Bank of Qatar
Qatar Industrial Development Bank
Qatar Islamic Bank
Al Ahli Bank
Qatar International Islamic Bank
Other banks in Qatar include two Arab banks and six foreign ones:
Arab Bank Ltd.
Al Mashriq Bank
British Bank of the Middle East
Bank Saderat Iran
All the aforementioned banks are internationally active and the report focuses on Qatar Industrial Development Bank and The Commercial Bank of Qatar for analysis purposes. The reason for choosing these banks is because of the fact that they initially originated in Qatar and the nation’s important central banks competing with other foreign banks established in the country in international banking and cross border finance.
From the arguments in the previous sections it is evident that the state of Qatar has made tremendous progress in its economy and is still growing to become one of the riches countries in the world. The oil resources in the country are the backbone for the country’s economy. It is also evident that the country is actively participating in Industrial Development Bank (QIDB) and Commercial Bank of Qatar is presented in order to give a detailed analysis to the reader about the country’s banking sector. Then in chapter 6 the implications of Basel II Accord on the banks are discussed followed b conclusion and recommendations in chapter 7.
Chapter 5: Case Study
In this chapter a case study analysis of Qatar Industrial Development Bank and Commercial Bank of Qatar are discussed. The aim of this case study is to present the reader with vivid facts and details of the banking sector of Qatar and the internationally active banks in Qatar. Alongside, the analysis of these banks provides a deeper insight of the implications of Basel II Accord on the Banking sector of Qatar as a whole.
Sources of data:
The case study analysis focuses on the bank’s operations and its current situation in the country’s economy. The data used are mainly from journals, annual reports and white papers. This is due to the fact that the information annual reports and the current information available on the news are up to date in doing the analysis and not to mention the fact that this report is being prepared in UK and going into Qatar for the purpose of meeting the banks in order to gain primary data is literally impossible at this stage.
Case Study 1: Qatar Industrial Development Bank
The Qatar Industrial Development Bank was established in 1997. The objective of the bank is to actively participate in the economic and industrial developme
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