2. BACKGROUND
• The Central Bank of Nigeria (CBN) in 2013 issued a framework on Regulatory Capital
Measurement and Management for the Nigerian Banking System for the
implementation of Basel II/III in Nigeria.
• The framework specifies approaches for quantifying the risk weighted assets for
credit, market and operational risk for the purpose of determining regulatory
capital.
• Although the guidelines comply significantly with the requirements of the Basel II/III
accords, certain sections were adjusted to reflect the peculiarities of the Nigerian
Environment
• The Basel II/III framework stipulates a minimum level of capital that banks must
maintain to ensure that they can meet their obligations, cover unexpected losses; and
can, very importantly, promote public confidence.
• Basel II/III is a three-pronged approach relying on three Pillars -Minimum Capital
Requirements (Pillar 1), Supervisory Review Process (Pillar 2) and Market
Discipline (Pillar 3)
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3. THREE PILLARS OF BASEL II & III ACCORD
• Pillar 1 Minimum Capital Requirements: It prescribes the capital allocation
methodology against the core traditional credit, market and operational risks to
ensure these are adequately measured and that banks have adequate capital to
mitigate these risks.
• Pillar 2 Supervisory Review: It requires banks to establish a risk management
framework to identify, assess and manage major risks inherent in the institution and
allocate adequate capital against those risks. It emphasizes that supervisors should
be able to evaluate the soundness of these assessments
• Pillar 3 Market Discipline: It sets out to promote market discipline by requiring a
number of disclosure requirements in respect of a bank’s risk exposures, risk
assessment process and capital adequacy.
• Effective October 1 2014, banks were required to commence monthly Capital
Adequacy reporting, carry out an Internal Capital Adequacy Assessment Process
(ICAAP) on an annual basis and comply with the Basel II Pillar 3 disclosure
requirements on a bi-annual basis.
• In 2015, CBN revised the Capital Adequacy Ratio (CAR) reporting template and
existing guidance notes on Regulatory capital, Credit risk, Market risk, Operational
risk and Pillar 3 disclosure requirement for Basel II implementation in the Industry
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4. HOW BASEL ACCORD AFFECTS RETAIL/SME LOANS
• One of the main criticisms of the Basel 1 framework was because it lacked risk sensitivity.
All loans were subject to the same capital requirement regardless of the borrower’s ability
to repay the loan. E.g. a loan to an AAA company is treated the same way as loans to a
company with B credit rating. This led to the creation of Basel II accord.
• Under the new banking regulation, the way an SME is treated will differ according to the
approach chosen by the particular bank, Standardised or IRB, and according to whether
the bank includes the SME in the corporate or retail category.
• In the Standardised approach currently used in Heritage Bank Plc., we must classify our
exposures to risk according to various groups, and establish weights based on the credit
rating given to the SME by an external credit assessment institution.
• Basel II has additional rules for SME loans which is categorically the firm-size adjustment
for SMEs. Basel II accord aims to protect banks from unexpected losses on their loan
portfolio as opposed to expected losses. SMEs are associated with higher expected losses
than large corporate borrowers but these expected losses are covered by higher interest
rates/lower risk ratings on the loans.
• SMEs are exposed to more unsystematic risk than systematic risk and this means that the
default correlation for SME loans is lower than for corporate borrowers. The weak
sensitivity/correlation of SMEs to systematic risk and the positive effects of diversification in
SMEs portfolios advocate for a reducing of the SMEs risk weights. The Basel II accord
acknowledges this fact by including a correlation adjustment for SMEs which reduces
correlation according to firm sizes. This in-turn leads to lower regulatory capital charges for
SMEs.
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5. HOW BASEL ACCORD AFFECTS RETAIL/SME LOANS. Contd
• Since the provisions of Basel III first began to take shape, a number of estimates have surfaced of
the likely microeconomic impact of the new capital and liquidity requirements on economic output,
ranging from the Institute of International Finance estimate of a 3.2% output loss relative to the
baseline over five years (IIF 2010) to the FSB/Basel Macroeconomic Assessment Group estimate
of a 0.31% loss over four years (MAG 2010). These estimates have, in turn, informed the detail of
the regulations and the rate of implementation
• An SME impact assessment is not merely a concession to a group of stakeholders; it is essential
to the correct design and implementation of capital and liquidity requirements. In assessing the
likely impact of Basel III the MAG (2010) readily acknowledge the effect on lending to SMEs as a
significant risk to their estimates
• Impact assessments for banking regulations are extremely quantitative affairs, focusing on
extracting robust forecasts out of vast volumes of backward-looking data and some forecasting
assumptions.
• Assessing the impact of Basel III is a difficult enough task without demanding a detailed discussion
of SMEs. However, there are particular reasons for which producing a precise quantitative
estimate of the cost to SMEs might be even more problematic.
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IMPACT ASSESSEMENT OF BASEL III ON SME LOANS
6. • Lack of robust data: Although some data on borrowing by SMEs are available, data on
SME output that can be readily correlated with credit supply are much harder to come by
(ACCA 2010). In fact, beyond a relatively small number of SMEs on company registers,
which are always a small minority of the SME population in any case, smaller and
informal businesses are invisible to policymakers and regulators in most countries.
• Lack of a common SME definition: It is often argued that, without a common definition
of SMEs, it is extremely difficult to make any statements about the ‘global’ SME sector
(ACCA 2010). Individual governments devise their own national definitions according to
policy needs, while banks use an entirely separate array of definitions dictated by market
segmentation (Cap Gemini et al. 2010) and in fact treat some loans to very small
businesses as consumer, rather than commercial lending
• Lenders’ discretion: The MAG (2010) acknowledges that the behaviour and choices of
lenders are crucial determinants of the impact of Basel III. Because small businesses
represent, to most lenders, a distinct business segment complete with its own lending
structures (see CapGemini et al. 2010), changes to lenders’ business models can imply
dramatic changes in individual institutions’ supply of finance to SMEs as a whole which
are however extremely hard to model
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Certain Challenges with Retail/SME Loans
7. BASEL BLIND SPOTS
• Banks at the centre of the Global financial crisis lacked strong incentives to devote
adequate attention to due diligence of individual mortgage loans because their main
profit margins were derived from securitisation of loans rather than from a prudent
credit-risk assessment of individual loans.
• A major focus of systemically important banks has been to maximise profits by
engineering unconventional assets, rather than making sure that each loan
individually is worth the credit risk. Risk-weighted regulation shifts banks’ attention
and resources away from conventional lending. (Slovik 2011) .
• These findings suggest that Basel III is not optimally suited to the risks facing the
global financial system. In many ways, capital regulation alone is oblivious to the
realities of lending to SMEs and gives banks incentives to avoid conventional lending
altogether.
• It is therefore important for global regulators to resist complacency and devise further
means, outside the framework of Basel III, of monitoring tail risk, as well as to rethink
the scope of Basel III and ensure that it applies only to those sectors that stand to
benefit from its provisions.
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8. SME LOANS
• According to the Prudential Guidelines for licensed banks (2010)-SME Loan is a
loan provided to a Small and medium enterprise (SME). A small and medium
enterprise is defined as any manufacturing enterprise with a maximum turnover of
N500 million and assets of N250 million (excluding land and working capital).
• Policies on SME Loans- Banks shall prepare a comprehensive policy for SME
financing duly approved by their Board of Directors. The policy should be reviewed at
least every three years
• Source and Capacity of Repayment and Cash Flow backed Lending: Banks shall
specifically identify the sources of repayment and assess the repayment capacity of
the borrower on the basis of assets conversion cycle and expected future cash flows.
In order to add value, the banks are encouraged to assess conditions prevailing in
the particular sector / industry they are lending to and its future prospects. The banks
should be able to identify the key drivers of their borrowers’ businesses, the key risks
to their businesses and their risk Mitigants.
• Securities: Banks shall decide on appropriate security for SME facilities
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9. PROVISION REQUIREMENTS (Under the Prudential Guidelines)- SME
LOANS
Category Classification Days past due % of Provision
1 Watch list Where mark-up/ interest or
principal is overdue (past due) by
90 days from the due date
0% of total
outstanding balance
1a Substandard Where mark-up/ interest or
principal is overdue (past due) by
90 days to 1 year from the due
date
25% of total
outstanding balance
2 Doubtful Where mark-up/ interest or
principal is overdue (past due) by 1
year to 1.5 year from the due date
50% of total
outstanding balance
3 Very Doubtful Where mark-up/ interest or
principal is overdue (past due) by
1.5 years to 2 years from the due
date
75% of total
outstanding balance
4 Loss Where mark-up/ interest or
principal is overdue (past due) by
more than 2 years from the due
date
100% of total
outstanding balance
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Short term financing facilities: These are Bank’s facilities with Maturities up to one year
10. RETAIL LOANS
• Prudential Guidelines defines Retail Loans as- financing allowed to individuals for
meeting their personal, family or household needs. The facilities categorized as retail
financing are as follows-
Credit Cards mean cards which allow a customer to make payments on credit.
Supplementary credit cards shall be considered part of the principal borrower for the
purposes of these guidelines.
Auto Loans mean the loans to purchase the vehicle for personal use.
Housing Finance means loan provided to individuals for the purchase of residential
house / apartment / land. The loans availed for the purpose of making improvements
in house / apartment / land shall also fall under this category.
Personal Loans mean the loans to individuals for personal needs. (v) Any other
exposure to an individual borrower as may be categorized by the CBN.
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11. CONCLUSIONS AND RECOMMENDATIONS
• The findings suggest that it is both possible and necessary to recalibrate Basel III so
as to mitigate the worst of its effects on SMEs by simply aligning the regulatory
framework with its proper purpose: containing systemic risk and the negative
externalities involved in financial activity. The key is in recognising which elements of
financial institutions’ activity truly contribute to these and ensuring that these are
penalised, instead of penalising risks that are properly internalised by financial
institutions.
• Nonetheless, it is also important to realise the limitations of Basel III: there are
sectors to which it is not well adapted, and important risks that it cannot
accommodate. In fact, many of the same features that make the framework hostile to
SME lending also make it oblivious to true risk.
• Clearly regulators and governments around the world need to take a step back and
consider the current framework for capital and liquidity regulation. A wholesale review
of Basel III may not be possible any time soon, but if policymakers can, for now, focus
their energies on perfecting the trade-off between SME growth and financial stability,
a substantial share of the global economy will reap significant rewards without
endangering any other economic activity.
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12. REFERENCES
• CapGemini, Unicredit and EfMA (2010), ‘Small Business Banking and the Crisis:
Managing Development and Risk’, World Retail Banking Report Special Edition 2010
• IIF Working Group on Cumulative Impact (2010), Interim report on the cumulative
impact on the global economy of proposed changes in the banking regulatory
framework, (IIF).
• MAG (FSB/Basel Committee Macroeconomic Assessment Group) (2010a),
Assessing the Macroeconomic Impact of the Transition to Stronger Capital and
Liquidity Requirements (Basel: Bank of International Settlements)
• Prudential Guidelines for licensed banks (2010)-
http://www.cbn.gov.ng/out/2010/publications/bsd/prudential%20guidelines%2030%20j
une%202010%20final%20%20_3_.pdf
• Slovik, P. (2011), ‘Systemically Important Banks and Capital Regulation Challenges’,
OECD Economics Department Working Paper no. 916 ECO/WKP(2011)85,
December, , accessed 13 February 2012.
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