Why Asia's banks will lead the way in meeting capital requirements

David Urquhart explains why Asia is better positioned than the US or Europe for the introduction of new banking rules.

International banking regulators marked the second anniversary of the bankruptcy of Lehman Brothers, which saw the world’s banking system come close to collapse, by agreeing on rules that require banks to increase their capital cushions.

The most significant rule approved by the Basel Committee on Banking Supervision — a group of regulators from 27 countries — means banks will have to boost their reserve of common equity (common shares and retained earnings) to at least 7 per cent of their assets, weighted according to their risk, up from 2 per cent now. Otherwise, they face limits on dividends to shareholders.

The body suggested that in prosperous times national regulators should make banks set aside up to an additional 2.5 per cent of their assets to prevent credit bubbles.

Still to come could be even tougher requirements for the world’s biggest banks — so that banks that are too big to fail don’t fail. The new regulations don’t start until 2013 and won’t be fully in place until 2019 — a delay no doubt due to successful lobbying by Western banks.

US and European banks appear to have pushed back on stricter and more imminent reserve requirements because of their weak capital positions compared with Asian banks.

Two US banks — Bank of America and Citibank — are among the seven in the KBW index1 that appear to fall short of the new capital requirements, according to some analysis. So they may have to restrict dividend payments or boost earnings by trimming costs to meet the new capital requirements.

European banks are in even worse shape collectively. Germany is thought to have sought weaker regulatory requirements because its 10 biggest banks, including Deutsche Bank and Commerzbank, may need to raise more than 100 billion euros in fresh capital to meet the new regulations.

Safe as Asian banks

Banks in Asia, however, have high capital ratios and will be able to avoid the fundraising needed elsewhere to meet the new standards. The long implementation period to give banks time to improve their capital position is simply not needed for most Asian banks.

If you look at Asia collectively, Tier 1 capital is more than 10 per cent to 12 per cent, nearly double the 6 per cent Tier 1 capital ratio international regulators agreed on — something central banks and banks in Asia were quick to point out after the regulations were announced.

Part of the reason for Asia’s better position is that the cause of the recent crisis has been highly levered Western financial institutions and Western consumers.

The powerful forces of deleveraging created large headwinds for the US and European economies, even after central banks cut interest rates to close to zero, effectively printed money and governments undertook massive fiscal stimulus.

The feeble state of these economies, in turn, weakened the financial positions of their banks as bad and doubtful debts mounted.

In Asia (including Australia), central bank and government attempts to revive economies worked because financial institutions and consumers were not facing the powerful headwinds associated with deleveraging when monetary and fiscal stimulus was implemented.

Few banks or consumers were forced to sell assets in order to focus on reducing their debt levels, so the lower interest rates and government spending combined to deliver an economic growth path that has been a v-shaped recovery.

Looking out to 2013 and beyond, Western banks will need to carry more capital than they currently have, so they will need to either raise capital or restrain their lending growth when their economies recover.

This lending restraint will act as a brake on the growth rate of these economies during the recovery. Asian banks do not have this brake. For Asia, and its banks under the new capital requirements, it is business as usual.

Asia can partly thank the Asia crisis of the late 1990s for its sounder banking system now.

Regulators, especially in the countries that received International Monetary Fund bailouts, namely Indonesia, Korea and Thailand, have monitored banks closely since the region’s financial crisis in 1997-98.

It’s true that China’s regulators have imposed stricter capital controls over the past year, but this was because the record stimulus of US$1.4 trillion of new loans in 2009 has been so successful that China now needs to avoid creating problems that arise from excessive growth, such as inflation.

China also wants to maintain the quality of its banks’ assets and the strength of their finances.

China’s financial institutions have announced plans to raise more than US$80 billion this year to replenish capital, but this is for Tier 2 capital, not Tier 1. China’s biggest banks and the largest publicly traded Chinese banks in Hong Kong already exceed the new capital requirements.

This is not to say, of course, that Asia’s banks won’t face challenges in coming years. It’s just that meeting new international capital requirements is unlikely to be one of them.

David Urquhart is portfolio manager of the Fidelity Asia Fund.