The Effect of Basel III on Philippine Banks: The Case of First Metro Investment

Corporation
in partial fulfillment of the course requirements in
PRCECON

Submitted to:
Mr. Angelo Taningco
Submitted by:
Christofer Tan
Submitted On:
Dec. 6, 2014

I. Introduction

Background of Study

The Base Committee on Banking Supervision was established on 1974 and since then it
has been formulating and recommending the best banking standards and practices. Generally,
their fundamental principle is a bank should always have ample capital to cover the different
risks they take. In 1988, they issued Basel I which is the first banking framework that is
primarily concerned with credit risk however was then refined to account for market risk. In
2004, they released Basel II. This was to cover the financial innovations of the years passed and
it incorporates operational risks to the framework. In effect, this refinement was simply done to
modernize the framework as a whole.

Some of the fundamental assumptions of financial institutions has been proven to be false
during the financial crisis of 2008. Thus, on December of 2010, they released yet another
refinement to the framework, the so-called Basel III. This framework presents new rules which
were much tighter and stricter than ever before. This was intended to solve the banking problems
made apparent by the financial crisis and to minimize the probability of them happening again.
Essentially, this aims to increase both the quality and required quantity of banks' capital and in
turn making banks more capable to absorbing risks and reducing the possibility of future banking
crises (ParconSantos, & Bernabe, Jr., 2012).

Basel III attempts to plug the loopholes present in Basel II by recommending steps to
further strengthen the overall financial system. Basel III strengthens the three Basel II pillars,

which are Minimum Capital Requirements, Supervisory Review Process, and Disclosure &
Market Discipline, by proposing many new capital, leverage, and liquidity standards to improve
regulation, supervision, and risk management of the banking sector.

Capital standards and new capital buffers will require banks to hold more capital and
higher quality of capital than under Basel ll rules. The new leverage ratio introduces a non risk
based bank measure to supplement the risk based minimum capital requirements. The new
liquidity ratios ensure that adequate funding is maintained in case of crisis.

ln Basel II, The first Pillar focused on minimum capital requirements. in Basel III, these
minimum capital requirements were enhanced and new liquidity requirements were introduced.

Enhanced minimum capital requirements are:

(1) Quality and level of capital - Higher Minimum Tier 1 Common Equity Requirement from 2%
to 4.5%, Higher Minimum Tier 1 Requirement from 4% to 6%, Minimum Total Capital Ratio
remains at 8%.

(2) New Capital Conservation Buffer This is used to absorb losses during period of nancial
and economic stress. Banks will be required to hold a capital conservation buffer of 2.5%.

(3) Countercyclical Capital Buffer - A countercyclical buffer within a range of 0% to 2.5% of

common equity or other fully loss absorbing capital will be implemented according to national
circumstances.

ln effect, these increases in capital ratios, stricter rules on eligible capital, and higher capital
requirements may push the cost of capital, which will necessitate close monitoring as well.

On the liquidity side, on the other hand, enhanced liquidity requirements are:

(1) Liquidity coverage ratio - This was set to ensure sufficient high quality liquid resources are
available for 30 days survival in case of stress scenario.

(2) Net stable funding ratio - This was set to promote resiliency over longer term time horizons
by creating additional incentives for banks to fund their activities with more stable sources of
funding on an ongoing structural basis.

In effect, banks are challenged to improve and more frequently produce regulatory
liquidity risk reports and merge their current risk and finance systems to meet the new Basel Ill
Liquidity Risk ratio requirements.

Next, the second pillar in Basel III enhances the Supervisory Review Process for firmwide risk management and capital planning. This enhancement ensures that banks have adequate
capital to support all the risks in their business. Also, these encourage banks to develop and use

better risk management techniques in monitoring and managing these risks such as managing
risk concentration. There will also be incentives for banks to better manage risk and return in the
long run through sound compensation and valuation practices. Trading books will be subject to
stressed value at risk requirement. Lastly, such supervisory review will enable early intervention
of supervisors if banks capital doesnt not sufficiently buffers risk inherent in their business
actives. Hence, all in all, the second pillar basically intends to ensure that banks have enough
capital to support the various risks they take.

And lastly, the third pillar in Basel III enhances the Risk Disclosure and market discipline
of banks. These enhancements include the revision of disclosure requirements. Also, it enhances
disclosure on detail components of regulatory capital and their reconciliation to reported
accounts, as well as requiring a comprehensive explanation of how a bank calculates its
regulatory capital ratios. All in all, the third pillar, essentially, is a discipline followed by banks
that complements the first 2 pillars (BIS, 2011).

On January of 2014, the Philippines adopted this new banking system. It is said by the
Banko Sentral ng Pilipinas that this was primarily done in order to strengthen bank capital to
better absorb losses and introduce a new global standard on liquidity risk management. One of
the changes made on the minimum capital requirement is that the capital adequacy ratio
requirement or CAR is increased to 10%. Additionally, the new framework increases the
minimum CET1 ratio to 6% and the Teir 1 Capital Ratio to 7.5%.

Not only are we adopting this banking system rather early but we are also upping the
benchmarks, as most of these standards are higher than that of the international Basel III norm.
For example, the international minimum for CAR is only 8%. This is done to impose a safer
banking system in the country thus making banks less prone to financial failures. Also, the
international standard timeline of the BCBS gives banks until 2019 before fully implementing
this framework in order to give banks ample time to generate capital. However, since the
Philippines was doing better compared to neighboring countries, BSP decided that an earlier
adoption date is best (Banko Sentral ng Pilipinas, 2013).

CAR stands for Capital Adequacy Ratio; this is the ratio of a banks capital over its risk
weighted assets. This measures the banks ability to absorb its risks or in simpler words, its the
capital cushion of the banks against potential losses. Generally, the higher the ratio, the more
capable the bank is to absorb its risks. The formula of CAR is as follows:
CAR=

Capital Tier 1 Capital+Tier 2Capital

=
Risk
Risk Weighted Assets

Where Tier 1 Capital is the minimum capital needed for the bank to absorb its losses without
forcing the bank to halt its trading activities. While Tier 2 Capital, on the other hand, is the
capital that can absorb losses in the event of a winding-up and so provides a lesser degree of
protection to depositors.

Thus, with that all said, to meet this tightened standard, banks must adjust their books
thoroughly and for most banks this is not an easy task, especially with the limited time given.

Statement of Problem

Hence, the main problem that this paper aims to answer is how do bank adopt to this
newly imposed banking standard?

Objective of study

The primary objective of this paper is to find out how can banks effectively abide by the
newly imposed banking standards of the Philippines while retaining their profitability and
stability.

Scope and Limitation

This paper is limited to First Metro Investment Corporation as this is a case study of this
company. First Metro was incorporated on 1972 and started its operations as an investment house
with quasi-banking functions in 1974. Fast-forward to today, it has become one of the, if not the,
best investment house in the country with Investment Banking & Strategic Finance, Treasury,
and Investment Advisory as its main functions. Also, this study will only be limited to the microeconomic level and will not cover the macro-economic effects of the Basel III.

II. Methodology
As stated in the previous paragraphs, the objective of this study is to see how banks can
effectively follow the guidelines set by the Basel III. In order to achieve this, we take a look at

the case of First Metro Investment Corporation and how they have effectively transitioned from
the pre-Basel III era to today. We look at the different techniques and methods they have used in
order to abide by the new framework while maintaining profitability and stability of the
company. We also examine how they changed their entire business model in order to cope with
sudden and drastic change.

More precisely, we examine how they managed to adhere to new CAR constraints. As
mentioned earlier, CAR is a function of the banks capital and its risk-adjusted assets. Hence, the
bank will either adjust the numerator which is the capital or the denominator which is the risk
adjusted assets. From capital re-allocation to different risk management schemes, this paper will
take a deeper look the various approaches the company took to adjust the said parameters.

Looking at First Metro, they have basically use two main approaches in order to abide by
this new set of standards. First is by Divestment, which is essence just the opposite of investing.
More correctly, according to Kengelbach et al. (2014), divestment, also known as divesture, is
simply the reduction of some kind of asset to achieve another personal or corporate objective.
Thus, fundamentally, FMIC just divested their resources and used them for other investments
instead. This in turn helps increase their CAR, by lowering the denominator, to meet the new
minimum.

The other approach is by changing their central business model. While the first approach
focuses on meeting the new requirements set by the central bank, this next approach focuses on
maintaining their profitability. For most of the previous years, FMIC, being an investment house,

has been focused on investing. However due to the new constraints, it is becoming more and
more difficult for them to maintain their current income while minimizing investments. Thus,
they have shifted their model to have less investements and offer more financial services such us
undermining. In this case, bulk of their income now comes from fees from the services they
provide instead of the assets they own.

III. Data and Analysis

As stated in the introduction, one of the main requirements to be met by the bank is the
minimum CAR which also happens to be one of the most challenging to meet. Again, CAR is
basically the capital on hand of the institution over its risk weighted assets. Hence, in order to
increase this, one has to either increase the capital or minimize the assets.

First, we take a look at what they have done with the numerator, which is their capital. At
first glance at their statement of financial position, it can immediately seen that they have
increased their total equity to almost P19 billion in 2013 from the P14 billion the previous year.
In comparison, they only grew P3 billion from 2011 to 2012. Taking a closer look, it can be seen
that the bulk of this increase can be attributed to the increase in Retained Earnings, which
increased by almost P4 billion from P9 billion the previous year to P13 billion in 2013. Also,
retained earnings is considered a tier 1 capital.

Additionally, to comply with the more rigorous capital requirements the company
unloaded its held-to-maturity investments, or simply HTM investments, as one of its capital

raising strategies, as approved by the board of directors on February 2013. Immediately after the
approval, the company reclassified its entire HTM investments with principal value of P16.3
billion to available-for-sale investments, or simply AFS investments, since the company no
longer intends to hold these securities up to their maturity but is ready to sell them as soon as
possible given it is sold at a value that would favor the company. Out of the all the HTM
investments reclassified to AFS investments, P11.0 billion was already sold by FMIC which
generated P4.0 billion gain which is under Trading and securities gain.

Next we look at what they have done with the denominator, which is the risk weighed
assets. Again, by looking at their statement of financial position, we can see that they have
decreased their total assets from P87 billion the previous year to P82 billion in 2013. This can be
largely be attributed to the divestment the company has been doing all through out the year.
Looking at their income statement, it can be seen that their income from sales of assets is up
almost 7 billion from a minuscule P28 million in 2012 to a very high P7.5 billion the following
year.
Thus, by the end of 2013 the companys CAR was at a healthy 23.13% under Basel III
which is well above the minimum ratio.

Aside from the capital adjustments, with the enhancements in the supervisory review
process for firm-wide risk management and capital planning, the company is forced to lessen the
risks the company takes. This is evident as their maximum exposure to credit risk decreased from
P10 billion in 2012 to just P7 billion in 2013. Hence, less risk equals less reward which means
that this diminishes the companys ability to earn more.

With that all said, we take a look at how the fundamental business model of the company
has changed in order to accommodate these new requirements of the central bank. So to maintain
its profits given the decrease in assets and risks taken, the company shifted its focus from assets
to services. And instead on relying on their assets for their main source of income, they now
heavily rely on service fees and what not as their primary source of income. Looking at the
income statement, it can be observed that, setting aside the P7 billion from gains on sale of
assets which obviously ballooned due to the divestments discussed earlier, bulk of the
companys income now come from either Trading and securities gain or Service charges, fees
and commissions which is not the case from the years gone by. As the trading and securities
gain of 2013 alone has already surpassed the total income earned the previous year.

IV. Conclusion

Basel III, with its stingy regulations and benchmarks, has proven to be a very difficult
standard to abide by. However, as seen and proven by this case study, it is still possible to
maintain profitability and keep the money flowing while also following the new rules set by the
central bank.

Thus the problem of whether a bank can follow these newly imposed rules while
maintaining its stability has been addressed. With the proper reallocation of the companies assets
and equity, whether it be divesting your current assets or reclassifying your securities, it is indeed
possible to meet their requirements. However, this is not without consequence, as this usually

disrupts the companys stability due to its negative effect on income. On top of that, banks are
forced to carry less risk in order to ensure banks stability hence their income takes another hit.
Therefore, banks must find new alternate methods in order to recover what was lost and in the
case of First Metro, a change in their business model was the answer to the problem.

In the end, I would recommend further studies with regard to this new regulations and
how it affects banks as this case study has a very very small sample size of one. Also I would
recommend looking at how the Basel III affects the macro-economic factors such as lending rate
and loan growth as these were not tackled in this paper.

Reference:

Bank for International Settlements. (2011). International regulatory framework for banks (Basel
III). Available via the internet: http://www.bis.org/bcbs/basel3.htm

Banko Sentral ng Pilipinas. (2013). Banko Sentral ng Pilipas Memorandun M-2013-008:

Frequently Asked Questions on Basel III Implementation Guidelines. Retrieved from:
http://www.bsp.gov.ph/downloads/regulations/attachments/2013/m008.pdf.

First Metro Investment Corporation. (2014). 2013 First Metro Annual Report. Retrieved from
http://www.firstmetro.com.ph/assets/annualreports/2013%20First%20Metro%20Annual
%20Report.pdf

Kengelbach, J., Roos, A., & Keienburg, G. (2014, October ). Creating Shareholder Value with
Divestitures. Retrieved December 1, 2014, from
https://www.transactionadvisors.com/insights/creating-shareholder-value-divestitures

ParconSantos, H. C., & Bernabe, Jr., E. M. (2012). The Macroeconomic Effects of Basel III
Implementation in the Philippines: A Preliminary Assessment . BSP Working Paper
Series, 2012-02, 1-23.

A. From day one I have been tasked with a ton of reading materials, ranging from the
financial ratios to the different types of risks that banks are involved in. Thus, it has truly
been a learning experience for me, at least from a educational stand point. Moving on, I
was able to attend several meetings with regard to risk management and was able to see
the tools they use to calculate the risk they take which has been insightful. Likewise, it
has been a privilege to be able to attend several Bloomberg seminars which was equally
as insightful. With that all said, I still believe that the most important thing I learned the
past few months is what real work feels like, what nine-to-five, five days a week feels
like. I think that more than all the knowledge you get from the training, still its the
experience that most crucial. Its understanding how the corporate world works. Its
realizing the difference between the office and the classroom, its the understanding the
difference between your boss and your professor. In the end, after through it all, I can say
that experience is indeed the best teacher.
B. First and foremost, I believe that the 200-hour requirement is too short for a student to be
truly versed with the work environment. I believe in order for a student to have a better
grasp of what working feels like, the school must require longer hours. Also, 200 hours is
too short for a student to be trained well by the company. Usually companies like to
rotate their interns for them to be better exposed to the different departments of the
company. However, with only 200 hours, this is hard to do. Another suggestion is to
maintain the 200 hour requirement but now require students to work for 2 different
companies, this way, he or she can be more exposed to the different working
environments. Even better if the student is able to work for 2 companies from different

industries, not only will be exposed to different environments, this will also help the
student know what career path he or she should take.