The Implications of the Basel Regulations for the Sri Lankan Financial System

November 12, 2018        Reading Time: 5 minutes

Reading Time: 5 min read

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Joan Moonesinghe*

What are the Basel Regulations?

The Basel Capital Concordat, when it was first introduced as Basel I almost two decades ago, was aimed at harmonising bank capital globally. It is, essentially, a capital regulation to ensure that banks, which are inherently highly leveraged financial institutions, have a minimum level of capital relative to their risk exposures.

Basel I was a one-size-fits-all capital standard against credit risk (the core banking risk). It, therefore, did not have any form of risk differentiation. Basel II, however, introduced market risk and operational risk, and permitted risk differentiation with the onus passed onto banks to measure counter-party risk (using internal models) in the recognition that not all counterparties pose the same risk. In addition to risk differentiation, Basel II added supervisory review and market discipline, making it a three-pillar formula. Basel II also mandated banks’ Internal Capital Adequacy Assessment Plan (ICAAP) to take into consideration such sources of risk that are not part of Pillar 1 and which may, therefore, be difficult to quantify. Moreover, large organisations were required to develop a comprehensive framework to assess the overall adequacy of their capital allocation with regards to the key risks their business model is exposed to, and to elaborate a capital planning process aligned with their strategic and business plan.

However, Basel II’s complexity led most bank regulators to be preoccupied with it to the detriment of dealing with more fundamental macro-prudential problems unfolding in the market. The Global Financial Crisis (GFC) of 2008 eventually proved that Basel II had failed to provide the capital buffers necessary to prevent the failure of several international banks as well as many Domestic Systematically Important Banks (D/SIBS – predominantly in the UK and Europe). Basel III,¹ therefore, was developed as the response of the Basel Committee – the global standard setter for financial institutions – to the GFC.

Regulations introduced under Basel III

• An increase in the level of Common Equity (CET 1)—pure, paid-up capital and permanent reserves—from 2% to 7%. This is sacrosanct in the definition of bank capital and no dilution of this capital component should have been permitted.²
•  Tier I capital in almost all banks in Sri Lanka was well in excess of the 7%, and the Tier I component of total bank capital (Tiers I and II) was made up primarily of Tier 1 capital, so invariably it was 10% or more.
• Introduction of the Capital Conservation Buffer (CCB), i.e. the mandatory capital reserve/cushion to be built up to cover potential losses and the short-term Liquidity Coverage Ratio (LCR), i.e. the mandatory liquid assets ratio imposed on all banks, to be no less than 20% of total liabilities.
  • Both of the above have been mandatory for all banks in Sri Lanka since the inception of regulation in this country, as the Statutory Reserve Fund (SRF) and the Statutory Liquid Assets Ratio (SLAR), respectively.
•   Introduction of the leverage ratio (which complements and is integral to the ICAAP), a measure that is non-risk-based and applies to the absolute amount of a bank’s exposure, i.e., it is not risk-weighted. The objective is to limit the absolute level of business and exposures – both on and off balance sheet – that an organisation may adopt in relation to its capital base.

Can these regulations help prevent or mitigate an external financial shock on Sri Lanka?

On the basis of the three fundamental components to Basel III, the Common Equity Tier I (CET 1) and total capital ratios, the Capital Conservation Buffer (CCB) and the short-term Liquidity Coverage Ratio (LCR) have all been integral components of the prudential regulatory framework in this country from the inception of bank regulation.

If the Basel standards are indeed the internationally acceptable benchmark for measuring the resilience of a country’s banking system to withstand external shocks – like those that reverberated throughout the world in the last GFC – there is convincing evidence that Sri Lanka’s SIBs (which represent over 75% of total banking assets in the Sri Lankan financial system) are well-equipped with adequate capital buffers to weather these shocks. This conclusion is based on:

•  All SIBs have posted very comfortable Basel III capital ratios much in excess of the January 2019 requirements – 8,9,10 &16 in Table;
•  Key profitability indicators of Return on Assets and Return on Equity are at optimal levels allowing for the buildup of organic capital to augment capital reserves as well as to support further expansion of risk-weighted assets; and
• Strong operational performance is indicated by high levels of financial intermediation, credit to deposit ratios, strong credit quality (GNPA) and prudent credit risk management (NNPA).

In addition, Fitch affirmed the ratings on nine Sri Lankan banks (including the specialised banks NSB and DFCC) as “stable” last month. The key ratings drivers were:

• Long-term issuer default rating, national ratings and senior debt, which include the banks where ratings are driven by sovereign support and those driven by intrinsic strength;
• State banks including NSB reflecting Fitch’s expectations of extraordinary support from the sovereign in view of their ‘high systemic importance, quasi-sovereign status and their role as key lenders to the Government of Sri Lanka and full state ownership;’
• The ratings of the private sector banks being based on balance sheet strength with adequate capital buffers to cushion the effect of International Financial Reporting Standards (IFRS) 9 on loan loss reserves required to be made if any, particularly where it is seen that Non-Performing Assets (NPA) have increased, albeit marginally in some of the SIBs;
• The sustainability of the above ratings being contingent on almost all the banks—both state and private sector—building up their capital buffers to support asset expansion and their risk profiles.

The importance of the ICAAP discipline is, therefore, profound for the banks (as it would be for the regulators) to ensure that asset expansion moves in sync with adequate capital and prudent profit retention policies; and

• The stress tests required to be carried out by the banks on their capital under various stressed scenarios as specified in the regulatory guidelines (namely, adverse movements in NPA, in the exchange rate and interest rate) being an important component of the ICAAP and being closely monitored by the Central Bank.

Fundamental to the above is the solid foundation of the sound regulatory and supervisory framework that has been in place in the country for well over half a century, and which has been well ahead of the Basel regulations. This framework reflects the superior wisdom and ability of the Central Bank of Sri Lanka, working in collaboration with the banking system, to ensure that the Sri Lankan banks are well equipped to weather any external shocks without much balance sheet pressure.

In conclusion, Basel III was primarily intended for the internationally active banks which were affected by the GFC in highly developed regimes where the basic prudential regulations were not in place, where capital was severely compromised, and where risk exposures were highly excessive (to real estate and derivatives). We can be satisfied that the Sri Lankan banks, and indeed most banks in the Asian region, are well ahead of the Basel III curve for the reason that they are well regulated and prudently managed with adequate shock-absorbing capacity.

Notes

¹ Bank for International Settlements (BIS). (2018). Basel III: International Regulatory Framework for Banks. [online] Available at: https://www.bis.org/bcbs/basel3.htm [Accessed 9 Nov. 2018].
² McKinsey & Company. (2018). Basel III: The Final Regulatory Standard. [online] Available at: https://www.mckinsey.com/business-functions/risk/our-insights/basel-iii-the-final-regulatory-standard [Accessed 9 Nov. 2018].

*Joan Moonesinghe is a Fellow and Associate of the Chartered Institute of Bankers, London, and an Associate of the Institute of Bankers Sri Lanka. She is also former Director of Bank Supervision, Central Bank of Sri Lanka. The opinions expressed in this article are the author’s own and not the institutional views of LKI, nor do they necessarily reflect the position of any other institution or individual with which the author is affiliated.