Banks should reconsider their regulatory capital strategies

In the wake of recent fundamental changes in the accounting world, we have seen a number of guidelines; call them accounting standards, being promulgated by international accounting bodies.
As a lay person in accounting, you are probably wondering, why you should care.
Well, you should care because these changes have far reaching implications on the day to day operations of the banks.
And as you can imagine, every one of us has a certain interaction with the banks whether as a depositor, lender, borrower, investor, regulator or trader.
Although I am careful not to bore my readers with technical accounting terms, but to understand what is happening, you will have to bear with me as I sparingly use them.
Great impact
The impact of these changes to banks is far-reaching from operational, human capital, information technology to regulatory.
I will focus on the banks and how these accounting changes will significantly affect their regulatory capital ratios.
The introduction of the new lease accounting standard IFRS 16: Leases, which is effective from January 1 2019, will impact different sectors, from airlines, to banks and retailers, and whatever business one can think of.
And to banking, the implications of this change on a bank’s capital will be far-reaching.
As a normal consumer of bank’s products, your focus is mainly on the quality of services that you receive from the banks.
An ordinary consumer is mostly concerned with the convenience that you get by having a good and friendly branch near you.
I am cognisant that major technological changes have happened making traditional brick and mortar bank branches a thing of the past and this will continue to happen.
But as a matter of fact, even with these tech revolutions, banks still need premises for their branch operations.
As one would imagine, banks cannot tie-up vital capital to construct and out-rightly own buildings for all branches they operate in.
Consequently, most of them end up entering into lease rental contracts to acquire branch premises.

Balance sheet
The most notable impact on banks arising from the changes in the leasing standard will be the on-balance sheet recognition of leased corporate facilities and branches which are currently being accounted for as off-balance-sheet operating leases.
The recognition of a right of use asset on balance sheet will definitely have implications on banks’ regulatory capital requirements as this will increase the risk-weighted assets and, therefore, decrease their common equity Tier 1 capital ratios.
This may trigger non-compliance with the minimum regulatory capital ratios with its implications.
The new requirements will also impact the income statement due to a change in the nature of the lease expense.
Whereas under the current standard an operating lease expense is recognised straight in line with profit or loss over the lease term, the total periodic expense for an identical lease under the new standard, comprising amortisation and finance costs, will be naturally front-loaded in the earlier years when finance costs are at their highest.
Simply put, banks’ costs will be very high in the earlier years of implementing this standard and all these have capital implications as retained earnings make up part of the Tier 1 capital determinations.

Major change
The other accounting standard IFRS 9 on the other side, among other changes, introduces a fundamental change in the way banks will calculate losses on loans for defaulting customers.
The expected ‘credit loss’ model as the guideline prescribes will require that banks anticipate that the borrower will default on the loan upon giving it out.
Currently, banks have to wait until a customer actually defaults before they recognise the loss. The new model is expected to fundamentally increase the losses.
Research by several consulting firms indicate that loan losses could rise up to 50 per cent for some banks and is expected to become more volatile under the new standard.

Minimum capital requirements
From a regulatory stand point, it is too risky to rule out revisions in minimum capital requirements by the regulators to avert the impact of these changes, as such banks’ shareholders may need to be ready should regulators call on additional capital in the near future.
As banks ponder the next moves, members of the audit committees and boards need to be aware of these changes and what impact they have on strategic decisions such as recapitalisation. The expectation is that as we near the transition to most of these new accounting changes, discussions should start to take place in banks.