The Basel II accord on capital adequacy is set for implementation in 2006, with full implementation latest by 2008.
Indeed a great deal has been written about the subject, and yet there could well be an emerging consensus that a Basel III accord may well be in the making.
The main reason for this is the changing nature of banking and banking risks, given the huge amount of innovation that is going on in the industry.
In the UAE we do not see these elements in play as most of the banks, virtually without exception, are not really into innovation and new products; but internationally the convergence of securities, investment banking and even insurance products has meant a host of new risks emerging into the banking models.
However, the impact for the UAE banks will be quite heavy, and there is no doubt in my mind that most of them will have to go out and raise more capital.
The manner of Tier 2 capital calculations under the new accord will mean that the emphasis on the way provisions are dealt with will change. In addition, a new range of risks will also have to be accounted for, and this is certainly going to mean banks will have to create additional provisions and also go out and raise their capital levels.
The discussion can be very technical on the one hand and, simplistically stated, as meaning that the stock investors in the country should not mistake new capital offerings by banks merely as a sign for raising money to expand operations and balance sheets. It could well mean it is the banks raising capital to be prepared for the effects of Basel II.
However, expectations from the banking sector are abnormally high, and this is shown by the fact that even a slight drop in earnings are considered anathema, with the management usually blamed for a weaker performance. In addition, the market expectation remains that banks will give annual 20 per cent gains, on a year on year basis, in their profitability, and this is where the pressure comes from.
In a 3 per cent interest rate environment with traditional pure vanilla banking products, the chances are that banks have to pile on a huge amount of higher risk consumer finance to even come close to those numbers.
While the Central Bank has a relatively good supervisory system, the nature of the banking beast is such that you cannot micro manage everything, and there are a number of loopholes for banks to 'play' with their provisions.
The Basel II accord is a quantitative in approach, but it also tries to bring about a qualitative approach to the process. The difference between regulatory capital, as defined by Basel II, and economic capital as defined by the need for business, has to be more distinct.
Banks thrive on leverage, and the more leverage they can have the better they will fare, in theory.
However, the consumer side of banking remains most lucrative, and the fact is that as interest rates have come down the pricing of consumer finance has only had a marginal decrease - and this is where the Central Bank of the country should have been more strict. Given the much higher levels, and the net differential to the banks being so large, they have had a greater appetite to take more risks in this area.
I am positive that consumer credit in the country is much larger than the sustainable level for most of the banks and this is where the crunch could come into the system with the adoption of the new Basel II accord.
While the problem may well be manageable over the next few years, there has to be recognition that the banking system needs to adjust its strategies for this end of the market.
The unfortunate thing is that banks may well take the requirements for higher capital and adequacy as an interest differential and add to the cost of finance for consumer credit.
This might well mean that consumer credit will get more expensive - and this is something that the regulators will need to step in and prevent. Why should the client pay higher charges for the capital inadequacies of the bank?
The writer is the UAE-based president of Sher Consulting.
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