Obstacles Encountered by an Emerging Economy in Implementing Basel II : The Lebanese Experience

W.B./I.M.F/Fed. Seminar for Senior Bank Supervisors from Emerging Economies October 16 27, 2006 Obstacles Encountered by an Emerging Economy in Implementing Basel II : The Lebanese Experience Dr Amine Awad Board Member, Lebanon s Banking Control Commission Member of the Higher Banking Council October 19, 2006

Contents 1) Lebanese Banking Sector at a glance 2) Consultative Paper on Basel 2 Results 3) Scenario analysis & Simulation (Q.I.S.1.) 1) Basel 2 Implementation Obstacles 5) Key Challenges to implementing Basel 2 6) Lebanon s Master plan for the Implementation of Basel 2 General Preparations Skills development Pillar 1 Pillar 2 Pillar 3 Capital Structure 2

Basel I Accord Banking Control Commission 1988 Capital / Risk weighted assets 8% Capital / Risk weighted assets 8% Credit risk: One size fits fits all all 4 4 categories of of risk risk weights :0%,20%,50% & 100%. Off- balance sheet items converted to to an an on- on- balance sheet amount with appropriate risk risk weight applied 1996 (amendment) Market risk: Standardized Approach Models Approach 3

Basel II Accord Banking Control Commission Pillar Pillar 1 1 Minimum Minimum Capital Capital Requirement Requirement (>8%) (>8%) Pillar Pillar 2 2 Supervisory Supervisory Review Review Process Process Pillar Pillar 3 3 Market Market Risk Risk Credit Risk Credit Risk Operational Risk Operational Risk Market Risk Market Risk Simplified Standardized Basic Indicator Approach Standardized Approach Standardized Approach Standardized Approach Models Approach Foundation IRB Alternative Standardized Approach Advanced IRB Advanced Measurement Approach 4

1. Lebanese Banking Sector (at a glance) Banking Control Commission 30/06/2006 (billions of dollars) % of Total assets Total Assets Liquidity abroad Total Loans (Performing & non performing) Total Performing Loans Total Non performing Loans (Gross) (Unrealized interest + Provisions) Loans in Foreign Currency Total Sovereign Exposure of which in Foreign Currency Customer deposits Equity Capital Adequacy Ratio (31/12/2005) 79,179 10,5 18,910 (14,674) (4,236) (3,069) 16,212 41,420 21,705 61,405 6,593 22.91% 100% 13.26% 23.88% 18.5% 5.3% 72% of Total non-performing loans 20.5% 52.3% 27,42% 77.6% 8% 5

1. Lebanese Banking Sector Banking Control Commission 31/12/2005 Number of banks operating in Lebanon 64 Number of Lebanese Bank s (of which 9 with Foreign majority shareholding) Medium and long term investment Banks Branches of foreign Banks Islamic Banks 42 8 10 4 Total number of branches 850 6

2. Consultative Paper (CP) on Basel 2 Results October 2005 7

Distribution of Banks in Lebanon Banking Control Commission 41 4 45 Lebanese banks represent 30 Groups Lebanese banks (Foreign majority) Represent 93.05% of Total Assets (10) (4) (5) Foreign branches Islamic Banks Special cases (Small foreign majority / Workouts) 64 Total Number of Banks In Lebanon 8

CP Analysis 1-2 - 3-4 - Preparation for Basel 2 (Part I) Risk Management (Part II) IT Infrastructure (Part III) Ratings (Part IV) 9

1- Preparation for Basel 2 1.1 Existence of an action plan Total Assets No action plan 8.8% 1% Plan being finalized 64.7% 58% Plan in place 26.5% 34% Banking Control Commission plan in place 34% Plan being finalized 58% not included 7% No action plan 1% 10

1.2 Expected Approach to calculate Credit risk Simplified Standardized Approach Standardized Approach Foundation IRB 41% 47% 12% Foundation IRB 12% Standardized 47% Simplified 41% 11

1.3 Credit Risk: Intention to move to more advanced approaches No intention to move Standardized Approach Foundation IRB Advanced IRB 18% 29% 47% 6% Advanced IRB 6% No intention 18% Foundation IRB 47% Standardized 29% 12

1.4 Expected Approach to calculate Op. risk Banking Control Commission Total Assets Basic Indicator Approach 73% 68% Standardized Approach 24% 23% Alternative Standardized 3% 2% Standardized 24% Basic Indicator Approach 73% Alternative standardized 3% 13

1.5 Op. Risk: Intention to move to more advanced approach No intention to move 41% Standardized Approach 47% Alternative Standardized 6% Advanced Measurement Approach 6% Alternative standardized 6% AMA 6% No intention to move 41% Standardized 47% 14

2- Risk Management 2.1 Distribution of cost according to different activities Banking Control Commission Consulting Services Purchasing new computer software Training & rehabilitation of employees New employees 10% 50% 13% 27% new employees 27% Purchasing new software 50% Training 13% Consulting services 10% 15

2.2 Distribution of cost according to different kinds of risks Credit risk Market risk Operational risk 56% 20% 24% operational risk 24% Market risk 20% Credit risk 56% 16

3 I.T. Infrastructure 3.1 Data evaluation Highly adequate 18% Needs adjustments 58% Not evaluated yet 24% Banking Control Commission Total Assets 12.5% 75% 5.5% Not evaluated yet 24% highly adequate 18% Needs adjustments 58% 17

3.2 Evaluation of IT systems Highly adequate 6% Needs adjustments 59% Not adequate 29% Not Evaluated 6% Banking Control Commission Total Assets 1% 52% 39% 1% Not evaluated 6% Not adequate 29% Needs adjustments 59% highly adequate 6% 18

Managing the Unified data (Data Pooling) Independent Co. 11% ABL 22% Banking Control Commission BCC 17% Association of Banks Banque Du Liban BDL 50% 19

Rated before Not rated yet 4 - Bank rating 23.5% 76.5% Banking Control Commission Total Assets 58% 35% not included 7% Not rated yet 35% Rated before 58% 20

3. Q.I.S.1 on Basel 2 Scenarios Analysis & Simulation (as at June 30, 2005) 21

Population Under Study Banking Control Commission Number of Banks as at 30/06/2005 (Branches of Foreign Banks) (Banks with special case) Lebanese Banks 64 (10) (6) 48 Subsidiary Banks = 11 Groups of Lebanese Banks 37 Represent 94.04% of total assets 22

Credit Risk Sovereign Risk Banking Control Commission Placements with Central Bank Local Currency Foreign Currency Current (*) 0 % 0 % Basel 2 0 % (National Discretion) 100% (*) Basel I as adopted in Lebanon 23

Credit Risk Sovereign Risk Investments in Lebanese T-Bills (LBP) & Gvt Eurobonds (F.C.) Banking Control Commission Local Currency Current 0 % Basel 2 0 % (National Discretion) Foreign Currency 20 30-50 % 100% 24

Credit Risk Banking Control Commission Due From Resident Banks Local Currency Foreign Currency Current 20 % 20 % Basel 2 20 % 100% 25

Credit Risk Banking Control Commission Customer Loans Current Basel 2 Residential Commercial Loans against R.E. Collateral Retail Other Loans 50 % 50 % 100% 35% 100% 75% Unchanged (100% in case of no qualifying collateral) 26

Basel II : Market Risk Banking Control Commission Market Risk Capital Charge Calculation General Assumptions Risks considered : - Interest Rate Risk - Equity Position Risk - Foreign Exchange Risk Trading Book + Trading Book Banking Book Commodities Risk was not considered since Lebanese Banks do not take positions in commodities 27

Basel II : Market Risk Interest Rate Risk Banking Control Commission Assumptions On-Balance Sheet Positions only (Off-Balance Sheet positions are negligible) Trading Book : all instruments classified as Financial Asset or Financial Liability at Fair Value Through Profit or Loss including instruments held for trading (Only 19 Banks/Group out of 37 hold Trading Portfolios) 28

Basel II : Market Risk Interest Rate Risk Standardised Measurement Method General Capital Charge Risk Banking Control Commission Lebanese Government Papers (including BDL papers) in Local Specific Currency Risk (LBP) Maturity : MethodGeneral Risk 0% Risk Weight All Other Papers including : - Lebanese Government Papers (including BDL issues) in Foreign Currencies; - Lebanese Corporate Issues (Banks) in Local & Foreign Currencies; - All Other Types of Foreign Issues; 100% Risk Weight 29

Basel II : Market Risk Equity Position Risk Banking Control Commission Capital Charge Specific Risk Risk Weight 100% General Risk Risk Weight 100% Banks portfolios were considered illiquid and not well-diversified 30

Basel II : Market Risk Banking Control Commission Foreign Exchange Risk Shorthand Method 31

Basel II : Market Risk Market Risk Distribution Banking Control Commission Equity FX Risk Risk 8% 4% Interest Rate Risk 88% 32

Basel II : Operational Risk Banking Control Commission Operational Risk Capital Charge Calculation Basic Indicator Approach Operational Risk Capital Charge = 15% x Average Adjusted Gross Income (previous 3 years average) 33

Increase in Risk-Weighted Assets Banking Control Commission Billion USD 50 40 30 20 10 20 41 0 Current Basel 2 (CR + MKT + Op. Risks) 34

Contributing Factors to increase in RWA p. Risk 10% Market Risk 7% Loans 4% Banks 3% Central Bank 54% Lebanese Government T-bills & Eurobonds 22% 35

Results Sector Capital Adequacy 25% 20% 15% 21.79% 10% 5% 0% 10.73% Current Basel 2 36

CAR: Number of Banks Banking Control Commission 31 2 3 1 10 13 Current Basel 2 6 8 > 16% 12% - 16% 8% - 12% < 8% 37

Excess/(Shortage) in Equity Banking Control Commission Under 8% 8 Banks Above 8% 29 Banks Shortage 134 Million USD Excess 1.25 Billion USD Since simulation exercise the lebanese banking sector witnessed increase in equity of around USD 1.9 billion 38

Results CAR Nb. of Banks whose CAR<8% Basic Basel 2 10.73% 8 Stress Scenarios Residential & Retail in FC/y weighted 100% 10.54% 9 Sovereign Exposure in FC/y weighted 150% 8.55% 13 Banking Control Commission Sovereign Exposure & Loans in FC/y weighted 150% 7.85% 16 Shortage in Equity (M.$) 134 151 330 487 39

4. Basel II Implementation Obstacles 40

4 - Major Implementation Obstacles are in the following areas: Family owned banks except some banks in Peer group 1 Capital structure (90% of the banks equity is tier 1) Tiny Capital Market Different levels of management quality between groups of banks and among banks in the same group Lack of local professional skills for the new banking activities and in the modern management techniques (and high cost of outside skills). No rating agencies in the country Lack of local skills High cost of outside skills 41

4 -Major Implementation Obstacles are in the following areas (cont.): Data: limited availability & accuracy High dollarisation (F.C.) that impacts asset weightings Low rating of sovereign risk ( B ) Banks heavy exposure to lebanese sovereign risk in F.C. that is currently under - weighted Islamic banks not included in Basel 2 Accord: (competition problem) Need for more coordination between regional supervisors in the Basel 2 implementation process. 42

5. Key Challenges to the implementation of Basel II 43

5- Key challenges to the implementation of Basel II Opening of banks capital to the public Enhancing corporate governance practices Introducing new risk management techniques Encouraging the present trend of Lebanese banks with high skills and good corporate governance to more expansion in the M.E. region Developing expertise in the BCC & the Industry Encouraging banks rating 44

5- Key challenges to the implementation of Basel II (cont.) Banking Control Commission Financing banks with long term subordinated debt instruments Completing the regulation relative to the implementation of Basel II Cooperating closely with the regional supervisory bodies Setting the eligibility criteria that help the creation of local rating agencies (alliance with regional or international firms) Encouraging alliances with regional capital markets and changing the legislation in order to develop the lebanese Stock Exchange 45

In order to Face the above mentioned challenges, the Central Bank & The B.C.C. have set a Comprehensive Master Plan with a time schedule for execution. The Master Plan has taken into account that the three pillars should be implemented, because they are viewed as equally important to the success of the new regulatory framework. 46

6 - Lebanon s Comprehensive Master Plan for the Implementation of Basel II Banking Control Commission 2004-2005 2006-2007 2008 Study requirements Assess Capabilities Define needs Training BCC & Banks staff Define Approaches Issue Regulation Update Frameworks Develop capabilities Enhance Competency Effective Implementation Monitoring and Supervising Parallel Running Central Bank / Banking Control Commission / Banks 47

6.1 General Preparations Banking Control Commission Subject Actions Taken Date Training Running simulations Basel 2 Task Force Consultative Papers (CP s) Home - host Supervision BCC staff have participated in regional and international seminars and workshops. Main subjects: Risk focused supervision, Risk Management, Corporate Governance, Basel 2. Scenario analysis & simulations are being done to assess the impact of Basel 2 on Lebanese banks (mainly Pillar 1). A special team (task force) has been formed to plan the implementation of Basel 2. BCC conducted a survey (consultative paper CP1) on Basel 2, aiming at: Estimating the level of readiness of banks Raising awareness of banks Enhancing direct dialogue with banks. As a host supervisory authority of many Internationally Active Banks, the BCC has signed several Memoranda of Understanding with their home supervisory bodies: the FSA, The French Commission Bancaire, The Cypriot Supervisory authority Since 2000 Since 2003 February 2004 July 2005 2005 48

Subject Actions Taken Date Banking Control Commission Regional Cooperation Sharing experiences Corporate Governance Higher Basel II Committee Basel 2 Project Managers Second Consultative Paper (CP2) Lebanon is a member of two regional supervisory groups: the Arab Banking Commission and the Commission de controle des pays francophones. In its comprehensive working paper on Pillar III presented to the Arab Monterey Fund, The BCC suggested the creation of a Regional Accord Implementation Group to promote greater interaction between regulatory authorities in the region. Organizing several regional seminars in Beirut with collaboration of the FSI and many regulatory agencies. The IFC conducted a survey in collaboration with the Association of Banks in Lebanon about Corporate Governance in the Lebanese banking sector. Decision taken on Gradual implementation of Basel 2 starting from 1/1/2008: banks are requested to define their approaches to measure Credit and Operational risk, have an action plan, and appoint Basel 2 project manager for implementation. Provide the BCC with the name of the person in charge of Basel 2 Implementation. Issued the second Consultative Paper (CP2) which focuses on the Action plan for implementing Basel 2. 2003 June 2005 1999-2005 2005 February 2006 April 2006 July 2006 49

Subject Assessing Banks Action Plans Amendment of Capital Adequacy Ratio Actions to be Taken The Off-Site examination department will validate that the action plans of each bank is reasonable and realistic. On-Site examination teams, will monitor the implementation of these plans. Issuing a new circular that will amend the Capital Adequacy Ratio according to Basel 2. Date Banking Control Commission From 1/10/06 until 31/12/2007 September 2007 Implementation Procedures Training Parallel Running Regional & International cooperation Core Principles Regional Default Data Issuing a circular on the calculation of Capital Adequacy Ratio according to Basel 2. The BCC is planning to have examiners specialized in certain areas of Basel 2, and have most examiners capable of assessing the banks action plans (Capabilities and Implementation). Monitoring the implementation of the Standardized approach, and assessing the capabilities of banks that intend to implement more advanced approaches. Discussions with supervisory authorities to sign other Memoranda of Understanding. Jordan, Syria (In process) Egypt, Qatar and Switzerland. Update self-assessment to new revision of Core Principles, and make/ implement action plan accordingly. Pursue possibility of pooling of credit default data on Regional basis, and possibly integrate these. October 2007 On - going Starting from 1/1/2008 On going December 2006 December 2006 50

6.2 Skills Development BASEL II & RISK MANAGEMENT Banking Control Commission Total number of trainees ABROAD 100 LOCAL 157 Coverage ratio (technical staff) 125% 176% Total training days 474 Average duration (days) 4.7 51

Number of seminars, organized by FSI and FSVC, and attended by BCC examiners since 2002 40 35 36 38 30 25 20 15 10 5 0 26 21 13 11 8 9 6 3 2002 2003 2004 2005 2006 Number of participants: 127 Nb of seminars attended Nb of participants (6 months) NB: These 44 seminars include those organized by FSI, FED, FSI & BCC, FSI & Toronto Center, FSI & SIC, FSI & BMA, and FSVC. 52

Number of seminars on BASEL II attended by BCC examiners since 2002 Banking Control Commission 2006 (6 months) 2005 6 10 19 41 2004 24 38 2003 16 36 2002 20 29 0 10 20 30 40 50 Nb of seminars attended Nb of participants Total seminars attended: 85 Number of participants: 251 Of which seminars held in Basel : 30 53

LAST BASEL II MAJOR EVENTS Awareness and Implementation 2005 * 3 Day Risk Management Seminar FSVC, GARP, CITI, BNP (I) All senior Risk Managers in the Country (110) + 30 BCC Examiners Launched LARP, (Lebanon s Association of Risk Professionals) *November 2005 2006 3 Day BCC annual meeting: All 97 Examiners included panels on Basel II * January 2006 1 Day BCC workshop: Basel II Implementation All BCC Examiners * June 2006 (delayed) 3 Day Seminar: FSVC, GARP, IMF All Basel II Project Managers in the Country + 30 BCC Examiners * Sept. 2006 (Delayed to January 2007) 54

6.3 Pillar I Minimum Capital Requirements 55

Subject Actions Taken Credit Risk Date Credit risk management Facilities Structure Investments in foreign papers Securitization Law Specialized Unit BCC issued circ. 238 setting requirements for Assessment & Management of Credit Risk. (Pillar I & II) BDL issued regulations on limits to overdraft facilities and mandating that banks finance Real Estate through Term Loans. BDL issued a circular regulating investment of banks in foreign papers Lebanese Parliament adopted the Law No. 705 that determines the legal Framework for the Securitization operations in Lebanon Market Risk BCC established a specialized Market risk department October 2002 January 2005 July 2004 September 2005 2001 Managing Interest rate Risk BCC issued Circular No. 250 that updates Interest Rate Risk Management criteria. April 2006 Managing Operational Risk Operational Risk BCC issued a circular that determines the basis of Operational Risk Management, using Basel Committee papers as a guide. September 2006 56

Subject Actions to be taken Date Q.I.S. 2 Classification of loans Local Rating Agencies Market Risk Market Risk calculation Operational risk calculation Carrying out a Quantitative Impact Study (Q.I.S), to help banks adopting the Standardized Approach Credit Risk Issuing a new circular that updates loan classification criteria. Setting the Eligibility Criteria that help the creation of local Rating Agencies (alliance with regional or international firms) Issuing a circular to update capital charge measurement criteria for Market Risk. Operational Risk Modifying the P/L forms required from banks to match with the Basic Indicator Approach. P.S. : A further modification will be made to meet the standardized Approach. December 2006 March 2007 Dec 2006 September 2006 November 2006 57

6.4 Pillar II Supervisory Review Process 58

Subject Actions Taken Date Corporate Governance Specialized Committees BDL issued circular no. 81 requiring all decisions of a bank to be subject to the prior approval of specialized committees. January 2001 Facilities to related parties BDL issued major amendments to the Related Parities facilities (decreasing the lending limits from 15 to 5%). November 2003 Key Positions in the financial & banking sector A circular has been issued requiring certain qualifications and certificates for some key positions in banks and Financial Institutions. March 2006 Principles of Corporate governance BDL issued a circular that defines the Principles of Corporate Governance in the Financial and banking sector according to Basel Committee requirements. August 2006 59

Subject IT Security Risk managers Basis of risk management Actions Taken Risk Management BCC issued circular No. 222 on IT. Security BCC issued memo no. 2/2004 requiring banks & FI to assign Risk Mangers. BCC issued circular no. 242 on the Basis of risk management. Date August 2000 August 2004 June 2005 Assessment of risk managers BCC off-site and on-site teams meet regularly with risk managers to asses their capabilities and the progress of their work and to discuss the challenges they face. On-going Annual Seminar Internal Controls Systems Generic policies & Procedures BDL/BCC organized the first Country wide (3days) seminar for Risk managers in banks. Internal Controls BDL issued circular no.77 requiring banks to have at least seven Internal control systems and to establish an Internal Audit unit. ABL assigned audit firm (Deloitte. & Touche) to issue Generic policies & procedures for internal controls systems. November 2005 December 2000 Sep.2002 60

Subject Actions to be taken Corporate Governance Date Principles of Corporate governance Second Annual meeting Enhancing Internal Audit activity Issuing a practical circular that helps banks in implementing the Principles of Corporate Governance in the Financial and banking sector according to Basel Committee requirements. Risk Management Organizing the second risk management Seminar which will focus on the practical considerations of Basel 2 & the latest risk management techniques. Internal Audit Issuing circular on Internal Audit based on the new standards of the Institute of Internal Auditors (IIA), which allows the Internal Audit units to follow up Basel 2 Implementation, specifically their role in the validation process. End of 2006 February 2007 April 2007 61

6.5 Pillar III Market Discipline 62

Subject Amendments to Balance sheet Accounting of financial Instruments Audit Manual Working Paper on Pillar III Actions Taken BDL issued important amendments on requirements of disclosure of banks balance sheet items reported to BDL & BCC. BCC issued Circular 245 introducing major changes in the accounting of Financial Instruments in Accordance with IAS 39. BDL/BCC published a comprehensive audit manual (2 volumes) in order to standardize audit procedures and serve as a practical guide for Compliance with rules & regulations. BCC presented during the first half of 2005 to the Arab Monterey Fund a comprehensive working paper on Pillar III. Date September 2005 January 2005 April 2005 June 2005 63

Subject Centralized Database for Financial Statements of companies Actions to be taken Issuing a circular requiring banks to disclose the Financial Statements of their debtors to a centralized database that is made available to all banks. Date December 2006 Modifying the disclosure forms Audit & Compliance Standards Manual Transparency Training Pillar III impact on Pillar I Modifying all the disclosures related to the Calculation of capital adequacy ratio to meet Pillar III requirements. Update working manual on a semi-annual basis, including Basel II Compliance issues Training Auditing staff on importance of transparency Ensuring that banks understand that failure to fully comply with Pillar III transparency requirements will impact their ability to implement more advanced models in Pillar I. Starting from end of June 2006 December 2006 (and twice a year) 2006/2007 On going 64

Subject Actions to be taken Date National discretion Items BCC will make publicly available its choices under National discretion to provide greater transparency. Second Half of 2007 Supervisory authority transparency BCC to publish updated information on regulatory policies and methodologies both applying to Basel II and otherwise. December 2006 65

6.6 Capital Structure 66

Subject Actions Taken Date New Capital Legislation Elements eligible for Tier 1 Capital Issuance of Preferred shares Lebanese Parliament has adopted the law 308 on issuing & trading with banks shares BDL issued circular 43 defining Tier1 & Tier2 Capital. BDL issued circular 90 setting the ceiling for issuance of non-voting Equity instruments. April 2001 April 2004 August 2004 After the above mentioned regulations, many banks have issued non-voting instruments (mainly Preferred shares), total amounts issued around 1.249 billion USD, which represent 18.9% of total Equity) 67

Subject Actions to be taken Date Introducing Tier 3 Capital Elements Issuing a circular that defines Tier 3 capital elements that can only be used to cover market risk (limited according to the 1996 Market risk amendment to Basel 1) October 68

Limits of issuing new Equity Instruments 100% 51% Voting instruments Tier 1 49% Non Voting instruments 69

51% Voting instruments Convertible Preferred Shares 49% 49% Non Convertible Non Preferred - Voting instruments Shares Innovative Instruments 15% 35% 70

Innovative Instruments Non Convertible (P.S.) Convertible (P.S.) Common Shares 15% 35% 49% 100% 71

E Mail: amawad@bccl.gov.lb 72