Middle East Bank (MEB) continued building and enhancing its information technology infrastructures for risk management. In light of MEB’s commitment to implementing Basel-III accord, we further developed our internal rules and procedures for Internal Capital Adequacy Assessment Process (ICAAP). We expect to have a complete set of internal rules and regulations approved and signed by the Board of Directors by the fall of 2016.
Central Bank of Iran (CBI) has taken major steps bringing the Iranian banking regulations in line with the latest Basel accords and International Financial Reporting Standards (IFRS). The CBI has emphasized implementation of IFRS particularly for matters related to disclosures and market discipline for the current reporting period (Year ended March 19, 2016); however matters related to fair valuations are to be introduced for the next reporting period; i.e. Year ended March 20, 2017. Although CBI has not yet issued guidance on capital adequacy and liquidity ratios conforming to Basel-II or Basel-III accords, we report these ratios according to the latest guidance from Basel Committee on Banking Supervision “Basel-III” documents in addition to current CBI rules. It should be noted that recently CBI issued preliminary recommendations for the implementation of Basel-II standardized model for the calculation of capital adequacy ratio; and, has sought comments from banks for a final decision yet to be made.
Table 1 illustrates some highlights of MEB’s risk profile.
MEB defines itself as a corporate bank, providing financing services to ongoing businesses for their working capital needs. Our loans mostly cover short-term needs of our customers, usually payable in three months and reusable up to one year. Longer period financing or project finance is only done when the viability of the project passes credit committee’s stringent requirement and funding is provided by the National Development Fund (NDF) against our guarantee. Larger projects may also be handled, but against the guarantee of a syndicate of banks. MEB’s strategy is to minimize market risks related to equity share holdings and so engages less than 2% of its assets in a diversified marketable equity securities portfolio.
We carried on our strategy of lending short-term loans to select corporate clients with whom we had developed and maintained strong long-term banking relationships. Our loan portfolio constitutes about 68% of total assets and consists mostly of working capital financing (receivables and inventory purchases) of our corporate clients and individuals who run their businesses as a proprietorship. MEB’s credit rating and credit extension is based on our assessment of the borrowers’ ability to generate the required cash flows, in addition to borrower’s ability to pay back the interest and principal at maturity of their loans; mostly in three months. This strategy has allowed the bank to maintain a ratio of doubtful loans to total loans of less than 1%, well below the 12% stated national average of doubtful loans as reported by CBI. The ratio of non-performing loans (more than 60 days late) to total loans is about 4.4% at MEB. The national average for loans 60 days past due was not available at the time of writing this report, however, one can expect a much higher figure than the nationwide doubtful loans of 12%.
Also, on the asset side, MEB’s short-term investments in equity stock market constitute less than 2% of total assets. MEB plans to reduce even further the short-term equity investments considering the low Sharpe Ratio and the very high risk weight associated with these assets. Our estimate of risk weight for our short-term investments is about 304%. For these short-term investments, the standardized Basel-III risk weight is 300%. These risk weights are to be contrasted with the Basel-I risk weight of 100% for short-term stock market investments. These high risk weights impose a policy of minimal and prudent short-term stock market investments. The overall asset side strategy of MEB is reflected in its strong capital ratios as depicted in the section “Capital Conservation Strategy”.
As of March 19, 2016, MEB’s Long-term and strategic investments were about 1% of total assets and were used for facilitating the financial needs of our customers. These investments include a brokerage house, an FX trade company and an investment bank, and an information technology company used for development of MEB’s core banking and related IT products.
The risk profile of our on balance sheet assets is such that considering an average risk weight of 107% for our loans, the average risk weight of our on balance sheet assets is about 94%. This results in MEB having a relatively high Capital Adequacy Ratio of 12.8%. Despite a relatively high CAR, we have stayed one of the most profitable banks in Iran. MEB’s profitability can be attributed to an efficient workforce, lower cost of capital and high regulatory interest rate for loans. MEB has a lower cost of capital because of the relatively large section of our deposits consists of our customers’ current account deposits.
We do not rely on a large number of branches for expanding our financial resources. Instead, we rely on our business borrowers to bring their banking activities and financial resources to the bank. Essentially with this strategy, we work as an intermediary to help our clients with occasional excess resources to finance our other clients with occasional short-term working capital needs. We also rely on the high quality of our services to attract the employees, managers and the customers of our borrowers to do their banking with us. We also attract high net worth individuals (HNWI) and business owners/managers and high income earners (HIE) because of the high quality of our services and the good reputation established among the business leaders. The Majority of the deposits and funds provided by the HNWI and HIEs are related to our corporate clients.
MEB’s depositors have stayed loyal despite the fact that higher deposit rates were available at other banks. During much of this reporting period, there was an unusual situation where the interbank overnight rates were higher than the regulatory deposits interest rate. MEB was generally a provider of funds in the interbank market which provided a window of opportunity to profit from the high interbank rates and low deposits rates. The reason for unusual high interbank rates was that CBI imposed a high interest rate penalty on banks with deficiencies in their statutory reserves. This high penalty interest rate pushed interbank loans to levels higher than regulatory fixed interest rates imposed on term deposits. This situation also forced some banks with deficient reserves to offer deposit interest rates higher than CBI regulatory deposit rates to avoid the much higher penalty for deficiency in statutory reserves.
Considering the current economic situation, MEB continues to maintain high liquidity and more capital than regulatory requirements. Despite higher than required liquidity and capital ratios, MEB has been able to stay one of the most profitable banks in the country for the reasons explained in the “Asset side strategy” of this report.
1.1.3 Capital Conservation Strategy The result of capital conservation strategy is depicted in the following table where several Capital Adequacy Ratios are estimated based on different models. MEB reports its capital adequacy ratio (CAR) based on several models: Basel-I, Basel-III Foundational Internal Rating and Basel-III Standardized Approach. Also, for March 19, 2016, MEB reports its CAR based on 2014 Basel-III Revised Standardized Approach for comparison with previous year March 19, 2015.
Risk Management in MEB consists of Risk Committee (RC) and Risk Department. The duties of the RC are modeled based on the Basel document entitled “Guidelines - Corporate governance principles for banks”, issued in October 2014. The RC consists of five Board members and the head of Risk Department (or Senior Risk Manager - SRM). SRM is responsible for reporting risk related matters to RC, discussing relevant information with members of the RC/Board members, as well as executing various resolutions of RC.
Risk Department operates under the guidance of Risk Committee (RC) and carries the policies set forth by the RC. The Risk Department is headed by the SRM and employs four additional risk analysts. The risk analysts and SRM share the duties of credit risk modeling, credit risk rating and liquidity risk measurements.
Because of the regulatory fixing of lending and deposits interest rates and an almost flat effective yield curve, interest rate risk comprised a non-significant portion of overall risks of MEB. A sensitivity analysis did not reveal a major impact on MEB’s profitability ratios from a significant regulatory change in interest rates. However, regulatory risks remain where MEB may face the loss of funds in case MEB abides by the CBI rules on fixed interest rates and other banks deviate significantly from CBI rules.
The equity stock portfolio of the bank is relatively small, however, it is regularly monitored and the relevant risk measurements such as VaR and concentration are reported.
Foreign exchange rate risk in MEB arises from the off-balance sheet commitments related to imports of goods. MEB engages only with clients who are not listed as a sanctioned entity and whose activities are allowed according to the imposed international sanctions. The foreign exchange commitments required direct dealing with CBI where the exchange rates were both guaranteed and allowed by CBI. MEB did not engage in a direct market related foreign exchange activities or hedging. With expected increase in international activities following the implementation of JCPOA, the foreign exchange risk is expected to increase for future reporting periods albeit such risk is always passed on to the importers or exporters.
The Board assures independence of the risk function from other business activities of the bank. The Senior Risk Manager leads the implementation of a rigorous ICAAP in MEB which is expected to be finalized by the fall of 2016.
MEB’s credit extension policies ensure CBI’s rules and regulations are properly implemented. MEB’s primary credit clients are incorporated entities with whom MEB develops and maintains strong long-term banking relationships. However, natural persons who manage their business activities personally and are not under a legal umbrella are welcomed and treated as proprietorships. Obviously in such cases, Chamber of Commerce registration and a proper tax code are necessities prior to extension of any facilities. The Concentration of MEB’s credit is in short-term requirements of its clients; namely inventory and receivable financing. Even international activities are limited to the importation of raw materials, spare parts and finished consumer goods. MEB occasionally arranges and participates in syndicated guarantee facilities when funding is provided through the capital market or State financed, National Development Fund.
The Risk Department assigns credit risk rates to non-financial incorporated clients based on their audited financial statements, past payment history, competitive position in the market, management quality and other qualitative information. Risk Department’s assessment, among others, is based on a client’s ability to generate the required cash flows for short-term financing of receivables and or inventories. All incorporated non-financial clients are independently evaluated by the Risk Department and are given an internal credit rate. Credit Department performs its own evaluation before submitting client information for risk rating. It is MEB’s risk policy to maintain an average credit risk rate of B+ or better. Collaterals as well as “supplementary collaterals” are used to augment the credit quality of clients with credit rates in the lower ranges.
184.108.40.206 Credit Risk Distributions
We provide several tables describing quality measures of the credit portfolio, including internal rating, late payment behavior, and concentrations.
The following table shows the credit quality of loans based on internal rating and the associated risk weights used for capital adequacy ratio calculations based on Basel-II IRB-Foundation Approach. In this approach the Loss Given Default is set to the Basel-III standardized value of 45%. The overall IRB-Foundation risk weight of loan portfolio for the 19 March 2016, is calculated to be 106.8%. The overall IRB-Foundation risk weight of loan portfolio for 19 March 2015, was calculated to be 105.6%.
220.127.116.11 Credit Risk– Borrowers payment behavior distribution
Risk department monitors and measures the payment behavior of its clients. These measurements help the risk department to improve its internal rating model. In the following table, the past payment behavior of current customers with outstanding loans are reported.
Credit Risk– Loans Distribution based on leverage and sales (BCBS 2014 Revised Standardized Approach)
For the previous financial year ended March 19, 2015, we reported the risk weight 115% for our loan portfolio based on BCBS 2014 revised standardized approach. The BCBS 2014 approach has been superseded by a new model issued January 2016. For reasons of comparability we continue to report based on the 2014 approach.
A daily report regarding changes in funds, uses of funds, costs of funds, asset profitability and return on equity is provided by the finance department. Additionally a weekly meeting of managing director, assistants to managing director and another senior level managers including senior risk manager is held where the reports are discussed and decisions regarding future directions of the bank are taken.
Risks related to short-term equity investments, and changes in foreign exchange rate and interest rate are discussed in this section.
18.104.22.168 Short-term equity Investments
The equity stock portfolio of the bank is relatively small, however, is regularly monitored and the relevant risk measurements are reported. The stock portfolio consists of 58 corporate shares (662,740 million IRR), 45 corporates are listed companies in Tehran Stock Exchange (599,699 million IRR) and others (63,042 million IRR) are shares of privately held companies.
The following table shows the concentration of MEB’s investments in Tehran Stock Exchange.
22.214.171.124 Interest Rate Risk on Banking Book (IRRBB)
MEB did not have any loans with floating rates, or significant optionality (e.g. early payment) affecting the profitability of its loans portfolio. IRRBB comprised a non-significant portion of overall risks of MEB because of the regulatory fixing of lending and deposits interest rates and an almost regulatory fixed flat yield curve. We have not observed any significant changes on profitability ratios due to regulatory changes on fixed rates of deposits and loans. However, regulatory interest rate risks remain where MEB may face loss of funds in case where MEB abides by the CBI rules on fixed interest rates and other banks may deviate significantly from CBI rules.
126.96.36.199 Interest Rate Risk on Trading Book
During the year ended March 19, 2016, there was no secondary market for trading bonds at discount or premium. All the bonds were traded at the nominal value plus coupons due. Towards the end of financial year (March 19, 2016), the government issued new bonds tradable in secondary markets with discount. For next year ending March 19, 2017 we would report interest rate risk on trading book.
Foreign exchange rate risk in MEB arises from the off-balance sheet commitments related to imports of goods. MEB engages only with clients who are not listed in internationally recognized sanctions lists and whose activities are allowed according to the imposed international sanctions. The foreign exchange commitments required direct dealing with CBI where the exchange rates were both guaranteed and allowed by CBI. MEB did not engage in direct market related foreign exchange activities or related hedging activities. MEB does not engage in profiting from changes to foreign currency exchange rates, however, occasionally, MEB would end up with open long or short positions in its normal activities for servicing clients engaging in import/export or other foreign exchange activities. With expected increase in international activities following the implementation of JCPOA, the foreign exchange risk is expected to increase for future reporting periods.
According to IRB-Foundation the average risk weight of loan portfolio was estimated to be 106.8%. We risk weighted our loans to other banks at a higher rate of 100%, because of our estimated low Basel-III capital adequacy ratio for other banks,. The total long term and short term investment of the bank in financial institutions were less than 10% of the bank’s Basel-III Tier 1 capital, so there were no deductions concerning these investments; however these investments were risk weighted at 250%. We risk weighted our investments in Tehran Stock Exchange at 300% . The market risk related to interest rate risk was estimated to be nil. The market risk due to foreign exchange rate fluctuations was extremely small and constituted about 0.01% of the total risk weighted assets. Regarding off balance sheet items, on average, the customers of Letters of Credit and Bank Guarantees have a much lower risk profile than our on balance sheet loan customers. For this reason we estimated the average risk weight of our off balance sheet items to be 70% equivalent to “BBB-“ credit rating.
For calculation of CAR according to Basel-III Standardized Approach, the average risk weight of the performing loan portfolio will be set to 100% as opposed to 106.8% for IRB-Foundation. We risk weighted our exposure to other banks at 100% considering our estimated low Basel-III capital adequacy ratios for other banks. The long term investment of the bank in financial institutions were less than 10% of the bank’s Basel-III Tier 1 capital, so there were no deductions from capital concerning these investments, however these investments were risk weighted at 250%. We risk weighted our investments in Tehran Stock Exchange at 300%. The market risk related to interest rate risk was estimated to be nil. The market risk due to foreign exchange rate fluctuations was extremely small and constituted 0.01% of the total risk weighted assets.
In order to perform our stress testing we assume that MEB will maintain the same balance sheet size and composition as of March 19, 2016 for the year ending March 20, 2017. We assume the credit quality of our clients would depend on national real GDP, which in turn would depend on average oil price for the year. The table below summarizes the severity of economic situations dependent on average oil price for the year and the effect on credit worthiness of our clients and the resulting loss/profit and the Capital Adequacy Requirement (CAR).
This item is the difference between the amount of provision already taken by the financial department for doubtful loans and the amount the Risk Department decided to take which is 100% of doubtful loans