Yes to capital adequacy in Israel
Israeli banks lead European counterparts respectively on the Basel 3 requirements However, future changes in accounting standards pose a challenge to the domestic banking system.
Imagine that you are competing in a long and difficult running competition. Final stretch goal in sight, but suddenly it starts to move away, the distance is not clear. Sounds frustrating? This is the feeling banks are facing in the world today that Basel 3 regulation will force to enter in a capital accumulation process and massive reduction in risk weighted assets in recent years, in order to meet the challenging capital adequacy goals.
Today, most European banks are still struggling to gain the required capital in full. On the other hand, Israel is quite different: all banks reached the capital adequacy ratio required by the supervision, set with more stringent capital targets. The success of Israeli banks capital accumulation is impressive since it was done by applying the standardized approach in the Basel, requiring greater allocation of capital against risks, compared with the most advanced and cost-effective models for risk weighted assets, implemented by the major banks in Europe.
The process in Israel was reducing credit growth and mortgage business (and thereby increasing the cost of mortgages), selling credit portfolios to institutional bodies and hedging activities – meaning a waiver of future profits, such as sales law guarantees insurance portfolio’s. Now the expectations are that the banks could increase credit growth and dividend distribution such as the authorization given to Hapoalim Bank to increase the dividend to 30% of the profit. However, over the horizon are dramatic changes in the Basel II rules and accounting standards is one of the most important issues in banking – provisions for credit losses – that could materially change the capital adequacy ratios of banks. To evaluate the capital needs of banks in Israel in the long run, we should analyze the expected effects of these changes.
Is Basel 4 good for Israel ? The Basel Committee is currently in the advanced stages of “updating” Basel 3, by replacing all the rules of capital allocation standard approaches (to credit, market and operational) and setting saving limits in capital that banks will be able to achieve using advanced models to calculate capital requirements compared with the results of standard approaches. The internal models for capital allocation for credit risk, the “Internal Model Based” (IRB) in the Basel, allow banks to calculate their own risk weighting assets (which is calculated allocation of capital) by estimating the probability of default and expected loss during credit default of different borrowers. On the other hand, the standard approach uses standardized risk weights which are normally much higher.
While the original rules of Basel 3 are designed to increase the capital volume in the banks, the purpose of the new rules is to increase the average risk weighted assets in the capital adequacy calculation in banks using the advanced approaches, and to narrow the gaps between the internal models and standard approach.
There are many significant changes and bankers around the world call them “Basel 4”, despite the Basel Committee which considers them as “calibration from” Basel 3. The result of an increase in the average risk is an increase in capital requirements. Therefore, damage to Europe’s largest banks, who use extensive internal models, is expected to be dramatic, since today the average risk weight of Europe’s largest banks particularly low, ranging from 20% to 40%.
Models for assessing the effect of “Basel 4” in the 100 largest banks in Europe, built by the consulting firm PwC, estimated that risk weights averages are expected to rise in the range of 40% to 65% compared to the current situation, and require raising additional capital in the range of 30% to 50% of the existing capital, amounting to more than a trillion euros. The result is estimated to be too harsh and would severely damage the credit supply and economic growth in Europe. European regulators started an all-out war against the Basel Committee to ease requirements, while sounding threats not to implement the new rules. We can evaluate carefully that in the final conclusions there will be adjustments that will make the result more moderate.
On the other hand, Israel, as already used in the Basel standard approaches, combined with more stringent capital requirements of the Bank of Israel, such as additional capital buffers in the mortgage portfolio, the average risk weights very high, over 70% of the risk assets. It can be said that the objectives of the “Basel 4” is obtained in advance. Moreover, it seems that at least in the area of credit risk, which is the bulk of the risk assets in the Israeli banks balance sheets, Basel 4 may improve the capital adequacy of banks in Israel, since it is more sensitive to risk, and may allow a lower capital allocation in relation to the current situation. A clear example is the mortgage portfolios of capital allocation, which is determined primarily by Basel 4 the LTV ratios (amount of the loan in relation to property value), which are particularly conservative in Israel compared globally.
The picture is more complex with regard to the future credit loss provisions. One of the most significant lessons from the financial crisis was that banks around the world allocated too little and too late for credit losses, and presented at the entrance to the crisis low provisions, which soared at the height of the crisis and gravely damaged their wealth. The main reason was the International Financial Reporting Standards (IFRS) and US generally accepted accounting principles (GAAP), which are still in effect, require a credit loss is recognized only after the occurrence of a loss event (Incurred Loss). The most obvious example of distortions was the US Bank CITI, whose share price dropped by 99% in the crisis and reflected market expectations that’s the banks’ capital will be deleted while the bank’s accounting capital in its financial statements was unaffected. This phenomenon did not occur in Israeli banks, which didn’t hold exposures similar to those abroad.
Therefore, the US Financial Accounting Standards Board (FASB) and Europe (IASB) decided to switch to expected credit losses. The meaning is on the day the bank allocates credit it will recognize immediately the amount of the estimated provision for expected losses, and will not wait in this matter until the occurrence of the actual loss. The FASB defines this change in accounting as the biggest revolution in banks for the past 40 years. At the outset, the aim was to create a global basis for the calculation of provisions for credit losses, but the attempt failed; therefore, within the framework of international standards, IFRS 9, which will take effect in January 2018, its required to allocate Provisions for credit losses for the expected next 12 months, and only if there has been a deterioration in credit quality, or a loss event has occurred its required to calculate expected losses over the credit period.
On the other hand, American Standard, 01-ASU and ASU 2016-13 in 2016, entering into force in January 2020, requires to set credit losses for the entire credit period. Israeli banks predict that banks supervision will require to implement the American standard, on time but its yet to be determined when. This means a much higher estimate of the complexity of the provisions, and the expectation of higher rate provisions compared to Europe and the situation today. The estimated difference will take into account historical data and current conditions, and make reasonable predictions about the future, and consider a variety of scenarios.
Senior European banks complain about the complexity and the lack of sufficient guidance in the accounting standards. It is expected that the models and methodologies selected by each bank will have a great impact on the results of provisions for credit losses, and created considerable variation between the banks. The challenge for banks in Israel are expected to be significantly larger in comparison to European banks, and create complex dilemmas regarding possible methodologies for assessing expected losses, from the data that will be used to try to estimate parameters models.
While the leading banks in Europe mostly make adjustments on the existing advanced models used in Basel, Israeli banks applying the Standardized Approach don’t have internal models from regulatory validation. Therefore, they will probably have to do some modeling and systems development infrastructure that necessitates significant investment of resources and a long preparation period.
In addition, the difficulty of developing models for assess the expected loss for the life of the credit, which are expected to be needed in Israel by American standards, was significantly higher in relation to the development of models for assessing losses in just one year, as required in Europe, especially for long-term credit.
What is the expected impact? It’s Too early to assess the effects of American standards which was completed only recently, the provision rates. In particular, it is difficult to assess the impact of Israel in light of the “unique” methodology of the group provision, and since it is not clear when and if the Bank is Supervision will decide to take towards implementing the new standards. The main reference point here today is to assess the effects of adoption of IFRS 9 estimates in Europe: a survey of the “European Banking Authority” (short – EBA), published in November, expects an average increase of 30% in provisions for banks, while the chairman of the IASB expects an increase of 35%.
But reliance on these estimates may be misleading: First, the EBA survey indicates banks’ use of the standard approaches to capital allocation, like Israel, provisions may grow by 100% and more. The reason is that the banks use the IRB approach, are already required to estimate the expected losses for credit losses, and enjoy the ease in IFRS 9 – If the provisions under the IRB exceed the expected loss under generally accepted accounting standards. On the other hand, banks applying the standardized approach have no calculation of expected losses, and can’t enjoy this relief.
Second, quantitative assessments are specified by the IFRS, as enacted by the US, Israel is expected to be implemented as stated, due to the need for a more stringent set aside for losses throughout the life of the credit, not just for 12 months. Various bodies from European banks mentioned that if they needed to implement IFRS 9 to specify which provisions for the entire credit period the increase of provision would be dramatically higher.
In terms of the impact on the Israeli banks capital, it seems that even here there is room for optimism. The standardization will be implemented in several years and will allow banks to accumulate more capital. In addition, the Basel Committee is in the process of consultations for the deployment of the effect of the new accounting standards on regulatory capital of banks over a number of years. Another factor to consider is that an increase in specific provisions in the new standards may justify a reduction in provisions in the Israeli banks’ balance sheets.
Initial assessments we made at PWC about the effects on banks ‘capital in Israel show that today with a 30% increase in provisions for banks’ balance sheets, similar to the average in Europe, most banks will remain with excess capital. A more stringent provisions of doubling the banks provisions will reduce balance the capital target by 0.3% to 1%, gaps which can be closed without significant business impact but with long term gradual implementation.
In conclusion taking into account regulatory and accounting changes, it appears that the banks in Israel enjoy solid capital ratios, which place them in good condition significantly better than their counterparts in Europe, and should support stronger business growth and equity multiples are higher than ever.