Ranee Jayamaha: Basel II - a roadmap for Sri Lankan banking system with
international comparisons
Opening remarks by Dr Ranee Jayamaha, Deputy Governor of the Central Bank of Sri Lanka, at an
event of lecture series, organized by the Association of Professional Bankers, Colombo,
18 December 2006.
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Mr. Theagarajah, Mr. Ajantha Madurapperuma, officials of the Association of Professional Bankers,
distinguished participants, ladies and gentlemen. Thank you for the invitation to deliver the opening
speech on "Basel II - a Roadmap for Sri Lankan Banking System with International Comparisons".
Let me deviate a bit from the topic and first deal with the flexible approach the Central Bank of Sri
Lanka (CBSL) has adopted in moving forward for full compliance of Basel II in the next few years. I will
then set out some of the key implementation issues which need to be addressed not only by us but
also by the Basel Committee and all host/home supervisors. For international comparison, I will
provide a brief a summary of how some of the other countries have fared in implementing Basel II from
2008 onwards. Mr Samarasiri, Director, Bank Supervision will outline a broad roadmap in
implementing Basel II.
The Basel Committee on Banking Supervision has released the document, "International Convergence
of Capital Measurement and Capital Standards: A Revised Framework" in June 2004 which is well
known as Basel II. Since then, the bankers and the regulators all over the world have been occupied
with the adoption of the revised Framework. The Accord in full is meant for the internationally active
banks but other banks are expected to follow suit. Although international institutions such as the IMF
and the World Bank have announced that the adoption of Basel II will not be a yardstick for measuring
compliance with the international best practice, sooner than later it will be the international norm and
they will start monitoring the progress. So, there is no point in debating whether or not we should
implement Basel II. The debate, if at all, should be how best to implement it and, where possible, be
ahead of others. Overall, the benefits to the industry in terms of improvements in risk management
and corporate governance and the supervisory action embedded in the Accord cannot be ignored.
Basel II has three mutually reinforcing pillars, namely, the Minimum Capital Requirement under Pillar I,
the Supervisory Review Process which is Pillar II and Market Discipline or Pillar III. The whole purpose
of this exercise is to make capital the key shock absorber in banking operations. For that, simple risk
mitigation measures in Basel I were not considered adequate. Therefore, a risk sensitive capital
requirement and risk mitigation practices were combined in a more meaningful manner. Banking is a
highly leveraged and risky operation and it is imperative to mitigate risks. With or without the Basel
Capital Accord, banks and financial institutions must find ways and means to identify risks, assess
them and put in processes and procedures to deal with such risks. Risk mitigation is not new to
bankers all over the world and same is true for Sri Lanka. Most of you who are sitting here this evening
are professional bankers of high calibre. Banking is like swimming across waters. Bankers know how
to swim. Regulators need not teach you how to do it. We can warn you of bad weathers, choppy
waters, high-tides and currents that can pull you down, but we cannot swim for you. That's why the
regulators expect the shareholders, boards of directors, CEOs, senior management and all employees
of banks to understand potential risks of their own operations and be ready to deal with them if such
risks were to occur. Therefore, all bank officials individually and collectively are responsible for risk
mitigation.
Basel II seeks to balance leveraging internal risk systems with supervisory prudence. It is also a
reflection of the rapid change in financial market innovations, advances in risk management and
enhanced supervisory approaches. In essence, we expect from the banking profession to objectively
and reliably identify risks, evaluate them and come up with appropriate risk mitigation measures. Many
enterprises fail due to unforeseen risks because they have not paid attention to risk mitigation. When it
comes to banking and financial institutions, we need to be much more careful, because they are the
custodians of other people's money.
Flexible approach by CBSL
In the process of adopting Basel II, CBSL will endeavour to adhere to the Basel criteria as far as
possible and to retain the spirit of the Accord. However, certain modifications have been made and will
also be made in the future to suit local conditions. Since Basel II provides a menu of approaches for
the measurement of risk to suit the level of sophistication of the banks, it is suggested that the banks
in Sri Lanka adopt the simplest approaches, initially.
Credit risk
For the measurement of credit risk under pillar I, we have requested banks to adopt the Standardised
Approach, which is very similar to the existing framework or Basel I and requires very little
modifications to the existing risk management systems by banks. The key to the success of this
Approach is the rating of counterparts. The banks should, as far as possible, encourage developing a
culture of credit ratings. CBSL will consider the representations made with regard to reducing the risk
weight applicable to below BB-rated entities initially in order to inculcate the rating culture, but this
should not be taken as the norm as we expect higher ratings to be considered for the purpose.
The Basel II Framework provides a preferential risk weight of 75% for claims that fall within the
regulatory retail portfolio. The qualifying criteria for retail and SME loans that would fall within this
portfolio have been modified to suit the local conditions and agreed with the banks. However, in order
to avail of the preferential risk weight, banks have to prove that this regulatory retail portfolio meet the
qualifying criteria.
Operational risk
Basel II introduces an explicit capital charge for a bank's operational risk, i.e. the risk of losses caused
by inadequate or failed internal processes, people and systems or by external events such as natural
disasters which calls for increased capital requirements. Throughout this year, the Central Bank
insisted on banks having comprehensive business continuity plans to ensure that there are alternative
arrangements if the core-banking functions or payment and settlement functions of banks were to fail.
We issued guidelines, discussed with banks on one to one basis and I believe that action has been
taken or is being taken to ensure that business continuity plans are done with utmost care and
dedication.
As with credit risk, Basel II provides a choice of 3 approaches to the measurement of operational risk
and initially, the simplest approach which is called the Basic Indicator Approach is recommended for
use by all banks. Accordingly, the capital charge will be based on the gross income of the banks. The
most complex Advanced Measurement Approach (AMA) can be made applicable at later stages as
techniques for the quantitative measurement of operational risk are still not widely used by Sri Lankan
banks. However, regardless of the approach used, all banks are expected to, in their own interest,
have in place sound internal operational risk management systems that are commensurate with the
nature of their business activities. From the regulator's point of view, it is difficult to leave risk
evaluation entirely to each bank's discretion particularly because of the need to assess how best each
bank uses its capital efficiently in dealing with general and specific risks. For market risk, the present
computation of the capital charge introduced in March 2006 will continue.
The preparatory work in this area and parallel calculations are at a satisfactory level and we hope that
banks will be fully ready by the beginning of 2008 to implement the processes they have already put in
place. However, the implementation process does not stop there. The essence of Basel II is to move
towards more advanced approaches which will require advanced risk management techniques and
improved corporate governance.
Adoption of advanced approaches
For pillar I, CBSL will consider permitting those banks which wish to adopt the more advanced
measurement approaches such as the Internal Ratings Based (IRB) approaches at a later stage, when
the capabilities at both the supervisory level and at the banks have improved and the necessary
infrastructure is in place. As a general principle, for the time being, CBSL will not mandate any of the
licensed banks to adopt the IRB approaches. The banks themselves should conduct their own
feasibility studies and analyze associated costs and benefits in order to decide whether to use the IRB
approach. The adoption of IRB approach would entail significant changes to their existing systems, the
collection of extensive data as well as the fulfillment of many other qualitative and quantitative
requirements. Such banks are advised to start building up the necessary data systems now itself in
order to be able to qualify for the advanced approaches and to plan the application of the ratings for
their credit management.
The IRB approach will permit the banks to use their own estimates for the measurement of credit risk
with regard to certain parameters. CBSL will stipulate the minimum qualifying criteria regarding the
comprehensiveness and integrity of the rating systems, including the ability for those systems to
produce reasonably accurate and consistent estimates of risk. This will be done in consultation with
the industry and by announcing a timeframe for permitting the Foundation IRB approach and the
submission of applications in 2007.
Irrespective of whether the advanced approaches are used or not, the Central Bank encourages all
banks to study carefully the more advanced risk management concepts and practices embodied in
Basel II and consider adopting those relevant to their risk management purposes, even though they
may not use them for capital allocation as such.
Pillar II - supervisory review process
This is a critical and integral part of Basel II which aims at ensuring that banks have sufficient capital to
support the risks in their business activities, encourage banks to develop and use better risk
management techniques, and foster an active dialog between the banks and supervisors regarding
capital adequacy and risk management standards. In this regard, banks are expected to have an
internal process for assessing overall capital adequacy in relation to their risk profile and a strategy for
maintaining the required level of capital, which is expected to be evaluated by the regulator, and
intervene at an early stage to prevent banks' capital from falling below prudent levels.
Accordingly, the implementation of Pillar II will be an extension of the current regulatory practice and
an elaboration and refinement rather than a radical change of existing practices. Where necessary, the
Central Bank will consider imposing higher capital adequacy levels for certain banks, depending on
their risk exposure. This is expected to result in developing a transparent and systematic approach for
evaluating the capital assessment processes of the banks and refinement of the CBSL's risk-based
approach to supervision to cover the Pillar II aspects. Its aim is to ensure the quality of risk
management standards rather than just setting capital against risks. In particular, the emphasis on
other non-credit risks such as interest rate, market, liquidity, concentration, operational, strategic, legal
and reputational risks should increase. This would be a natural extension of the risk-based approach
to supervision that is already applied and it should be viewed as a means of fostering closer
interaction between the industry and the regulator, rather than an imposition of regulations. To enable
the process, CBSL has begun to examine the legal requirements in this regard.
The internal capital adequacy assessment processes (ICAAP) of banks should cover the identification
and measuring of the risks and assessing how much capital is needed to support such risks. After
implementation, the CBSL will review banks' ICAAP as part of the risk-based supervisory process. In
addition, there will be an ongoing evaluation of the capital adequacy of banks, including stress tests. In
the process of evaluation, CBSL will review and evaluate the risk profile of the banks, the adequacy
and reliability of the ICAAP, and identify any weaknesses or inadequacies and necessary prudential
measures.
Pillar III - market discipline
The purpose of this Pillar is to complement Pillars I and II by encouraging market discipline through
the public disclosure of key information on risk exposures and capital adequacy.
Disclosures are applicable at the bank level as well as supervisory level. The level and content of Pillar
III disclosures will vary according to the measurement and calculation approaches adopted by a
relevant bank. In terms of Basel II, the disclosures would have to be made on an annual and
semi-annual basis. The implementation process will be developed in 2007 along with the
Sub-committee appointed for the purpose.
Key implementation issues
I. What is the appropriate capital adequacy ratio?
Under Basel I, the minimum capital adequacy requirement was fixed at 8% of risk-weighted assets
which is expected to be the minimum even under Basel II. In Sri Lanka, we have specified the
minimum capital adequacy to be at 10% from 2003, because it was considered necessary to have a
cushion of additional 2%, so that any unforeseen risks could be covered to some extent. Under Basel
II, the minimum capital adequacy ratio could be well above 10% or even lower than 10% if the bank
concerned is absolutely sure that it can mitigate all risks that are associated with its banking
operations. We will continue to use the yardstick of 10% for measuring the minimum capital adequacy
ratio consisting of 5% for Tier I. The other related issue is "Will 10% be adequate to cover market and
operational risks as specified in Basel II?" This is where the regulator is going to leave it in the hands
of the banks, but insist that the two new areas of risks are covered and all risks in banking operations
are calculated in an objective manner. It is also necessary for the banking institutions to go one step
further and take into account the risks of their clients also in a meaningful manner. This is certainly a
challenge for both the bank and also the supervisor. This challenge is not unique to Sri Lanka, but
common to all countries which have opted to comply with Basel II requirements.
To address this issue, banks in other countries have created a dedicated post in their institutions, i.e.
Chief Risk Manager, who will not only look into the risks in the bank's own portfolios, but also to the
clients' portfolios. The job of the Chief Risk Manager is to identify, evaluate risks and make
recommendations to set out appropriate processes in managing the relevant risks. The processes
should be acceptable to the senior management and the boards of the banks and also to the external
auditors and the regulators.
II. Appropriate risk evaluation techniques
Application of appropriate techniques for risk evaluation is an implementation issue. This is where the
modeling comes into play. Modeling is used as a popular technique for identifying, quantifying and
analyzing risks to enable the management of banking and financial institutions to decide on the
allocation of capital. But one need not entirely depend on modeling and be out of reality as modeling
will produce a statistical outcome depending on the data you feed into a set of equations or a
simulation model. Modeling also involves issues such as focus on loss data, validation, calibration and
issues on floors and ceilings. A practical issue on loss data is a different reporting system by banks,
especially when it comes to large losses. Secondly, some institutions may not reveal large losses at
all, but there are implications for operational risks.
III. Financial reporting and accounting issues
It is equally important for banks to take care of the financial reporting framework, be it international
accounting standards or local accounting standards given that Basel II requires financial reporting on
international accounting standards. Most banks in Sri Lanka will have to apply local accounting
standards and make necessary adjustments in their financial accounts to comply with Basel II
principles.
The Institute of Chartered Accountants is proposing to adopt the International Financial Reporting
Standards (IFRS), in particular IAS 39 and 40. CBSL will monitor the impact this will have on the
regulatory capital of banks and formulate policies in this regard taking into consideration the
international developments and practices of other regulators.
IV. Single borrower limits and other sub-limits
Should the regulators and supervisors continue with the regulations imposed on single borrower limits,
group borrower limits and aggregate limits that are in operation under Basel I, when they proceed to
Basel II from 2008 onwards? and when will the supervisors lift sub-limits such as the single borrower
limits that are currently in place and give more flexibility to the financial intermediaries? There is no
clear answer to this, but we hope that some of the commercial banks which are conscious of the
fullscale risk mitigation would be able to put in place appropriate processes and convince the supervisors
of their ability to move to advanced approaches of risk mitigation. At that point we need to adopt more
flexible attitudes towards limits and sub-limits in lending.
V. Involvement of boards, senior management and governance issues
Basel II requires the involvement of the senior management in the process of identification, evaluating
and mitigating risks. Does this mean that the senior management and the board members should use
some supervisory and monitoring powers to ensure that the technical and other officers continue to
engage in risk mitigation activities and that the board is satisfied with action taken by them? When
there are several layers of supervision, you might need a liaison officer to communicate with the
management and the board. The bank management should address this issue early and avoid serious
governance issues.
VI. Capturing new risks
When financial market innovation takes place globally, new products such as derivatives,
securitization will be introduced and they are likely to bring in new risks including operational risks.
How do we balance these new risks with other internal risks, systems, processes and also with
supervisory prudence? It is evident that Basel II enables banking to be based on more market driven
systems which is conducive to financial innovation and it requires setting aside risk mitigation
processes to deal with ever increasing financial innovation.
VII. Handling of operational risks
Should banks use stress testing or best practices in handling operational risk? Stress testing is merely
a tool which gives results on a reliable set of data. The banks need to compile a reliable database for
all operational risks that have arisen in the past 5 years or so and assess losses recorded during the
period. It is only then one can simulate and assess how much capital should be allocated if a similar
operational risk were to take place. Stress testing therefore is not only an add-on, but also a cushion
for management of risks in terms of validation and allocation of capital and it is one of the highly
accepted and commonly used tools.
VIII. Cross-border transferability issues
This is relevant to both supervisors and banks where home and host supervisors require to agree on a
common approach. Do banks which have global operations adequately take into account legal issues,
capital issues and assumptions about liquidity or capital transferability? How well are local managers
able to respond to host supervisory concerns? Currently, there is no sufficient data or experience to
deal with these issues. All know there are legal issues in transferring capital on cross-border basis
which are relevant to banks which have assets linked internationally.
IX. Compliance by financial conglomerates
Generally, a financial conglomerate is defined in terms of combined activities, such as banking,
securities and insurance. To what extent the financial conglomerate would use regulatory arbitrage
and not adequately assess the systemic problems is a key element under Basel II? This is particularly
relevant when it comes to similar financial products that can be packaged as an insurance product, a
banking product or a securities product as same business can be undertaken by either a bank,
investment bank or an insurance company. A key implementation issue is how to delineate the double
gearing and how to make available capital to deal with risks of both insurance and securities products.
As far as the EU is concerned, the financial conglomerates directive has already been issued and they
are expected to comply with them. USA's umbrella supervisory provisions are included in the Graham
Leach - Bliley Act. In Sri Lanka, we still have not come to terms in dealing with a consolidated or a
group-wide financial conglomerate.
X. Proper definition of capital
How do you identify new capital instruments such as hybrid capital and perpetual debentures? Should
it be Tier I or Tier II? One needs to be cautious here as hybrid capital can disappear given its
derivative nature. Currently, there is a wide disparity between the Basel II preparation processes in
Europe, USA and Asia. The issue of treating hybrid capital is significant as many Asian banks are
moving towards synthetic securitization in producing hybrid capital and exposing their portfolios to
credit risks, especially when equity participation has been synthetically securitized. The Basel
Committee has now decided to pay greater attention to give a standard definition for capital, hopefully
before the implementation begins in 2008.
International Comparison
Many countries have not tackled all these issues associated with Basel II, but there is notable
progress; some slowly, some moderately and some at a faster phase. For example, the Development
Bank of Singapore (DBS), the largest bank in Singapore and the 5th largest group in Hong Kong with
universal banking, providing full range of products and services for consumer, small and medium
enterprises, corporate banking, investment banking, fund management, trade finance, cash
management, securities and treasuries has taken a keen interest over the last 2-3 years in meeting
the Basel capital adequacy requirements and to implement the same in 2008. At present, it has a Tier
I capital ratio of 10.1% and a total capital ratio of 14.1%. The main philosophy behind the DBS's
approach is a balanced and enlightened one based on the management of capital. The approach is
led by the DBS's board and senior management and it is embedded within business of a whole group.
It is constantly reviewed by supervisors and communicated to the markets. The DBS group has
implemented a large-scale Basel II governance structure at several levels which is a success factor.
Its governance structure is based on DBS's credit model risk policy which sets out the minimum
principles and standards for the oversight control and management of all credit risks models in the
group and the roles and responsibilities. Several committees have been set up at the board level and
at group credit level to identify and manage risks. In terms of modeling, the model owner will design,
select and parameterize the key elements of the model. The model implementation is also by the
model owner who will work closely with the model users and performance monitoring unit. Above
them, are the model validators who are under the oversight by a Group Credit Risk Committee. The
Board's Risk Management Committee sits above these groups. It is a tightly knitted process which is
transparent throughout the DBS group and they are moving progressively, using internal rating in the
management of credit risks.
Despite using several internal rating models and regardless of the types of the models used, DBS
continuously review the risks which need to be mitigated using its practical knowledge throughout the
group. So the commonsense approach prevails there too.
Countries like Sweden have also begun addressing issues of Basel II implementation. Their case is
much more difficult than ours as they have spread among few of the Nordic countries in a significant
way. They are plagued with issues such as options and national discretions, different interpretations
and practices, reporting requirements across the EU system and the difference between legal and
operational structures in banking groups, basically, issues under pillar II. As a country within the
EU-system, Sweden will have to comply with common reporting frameworks for capital requirements
and have consolidated financial data. They have to deal with common recognition processes for
external credit assessment institutions and comply with home/host country guidelines. Sweden is
attempting to deal with these issues in a systematic manner during 2007, following the regulations to
be passed by its Parliament. Fortunately, Sri Lanka does not have to deal with such cross-border
issues as in many other countries.
South Africa is well ahead in terms of handling implementation issues on time targets. During
19992003, they have complied with core principles for banking supervision issued by BIS. In 2004, Basel II
regulations were issued and economic impact studies were completed in 2005. In 2006, consultations
have begun and in 2007 parallel runs will be conducted to implement Basel II in 2008. In fact, South
Africa has begun data capturing and mandatory requirements way back in 2004 and had discussed
appropriate models with banks opting to use internal rating based models. Informal field tests were
also conducted in 2006. In order to avoid supervisors performing redundant and uncoordinated
approval and validations of models and risk assessment by banks, South Africa has established
supervisory colleges to share information and coordinate supervisory actions. They have also
prepared "to-do" lists and MOUs with home/host supervisors.
Australia has defined capital more precisely and is on a moderate phase in moving towards Basel II.
The basic rule for Tier I and Tier II capital have been that Tier I capital should be of high quality with no
debt claims. They are permanent capital and also helps prevent failures. Tier II capital is subordinated
to depositors. Non-payment is a default and it is treated as an additional cushion in a failure.
These are some of the examples we were able to pick when Mr. Samarasiri and I attended the
Executives' Meeting of East Asia and the Pacific (EMEAP) held in Hong Kong last week. It gave us
some comfort that we are not that bad in international comparison. But, we need to recognize that
many countries have already laid down solid processes and procedures which are more comforting
than ours. The dedication of some of the banks like DBS is also worth noting as they have begun their
homework with great commitment across the group over the last couple of years. Although the
progress made by banks in Sri Lanka is satisfactory, we need to be more committed and move ahead
in 2007, faster than we did in 2006 in readiness for Basel II implementation.
Ladies and gentlemen, thank you very much for your patient hearing.