Sunil Mendis: Financial system stability and Basel II - the way forward
Inaugural address by the Chief Guest Mr Sunil Mendis, Governor of the Central Bank of Sri
Lanka, at the 17th Anniversary Convention of the Association of Professional Bankers,
Colombo, Sri Lanka, 28 August 2005.
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Ladies and Gentlemen
It is an honour for me to be invited to give the keynote address at this forum of eminent
bankers in Sri Lanka and distinguished persons from the international banking arena. I am
happy to see our friends from the Reserve Bank of India and from the Basel Committee who
will no doubt make this convention very lively for discussion on a subject which concerns us
all.
As Central Bankers we have a common interest in ensuring financial stability which impacts
upon the macroeconomic performance. Further, as monetary policy transmission takes
place through the financial institutions for the achievement of its target of economic and price
stability, the Central Bank has the responsibility for ensuring that the financial system as a
whole is sound. It should be strong enough to withstand internal and external shocks. We
must ensure that our payments and settlements system is protected from the risk of failure at
any cost since it is the conduit through which our economic business and commercial activity
is facilitated. The causes and consequences of the recent Asian financial crises are still vivid
in our minds and we from our part, as professional bankers, must endeavor to ensure that
they are not repeated.
The Central Banks can use both preventive measures and corrective action to maintain
financial stability. A constant and continuous monitoring of risks is a preventive measure.
Crisis resolution is a corrective action. A strong regulatory regime would ensure the former
and a financial safety net is an essential component of the latter. The two supplement each
other. The cooperation of all parties concerned in both these actions is of paramount
importance in maintaining financial system stability.
In Sri Lanka, as in most emerging economies, we have a bank dominated financial system.
Therefore, ensuring banking soundness will inevitably lead to financial system soundness.
The recent initiatives taken in this regard are significant - we have enhanced capital
requirements to reflect the increased leverage in the industry. Even regulatory capital is at a
comfortable margin above the international norm but is still only 10% of risk assets which is
the absolute minimum should these risks materialize. Therefore, increasing the minimum
capital requirements would provide a healthy platform for growth and expansion of banking
business. However, capital is the last line of defence. The more immediate needs are good
corporate governance and good risk management which will steer the banking system
towards good financial health.
A sound corporate governance regime would seek to promote the highest standards of
professional behaviour and integrity. Policies should be implemented to prohibit any
behaviour or relationship that diminishes its quality. This is very often evident in conflicts of
interest, connected lending, which is not on an arms length, and preferential treatment to
related parties. The independence of directors too is crucial where directors should have the
ability to exercise objective judgement, regardless of board structures or ownership
structures.
Well established corporate governance committees such as the Board Audit Committee
which oversees the bank's internal auditors, with objectivity and independence, should
comprise of non-executive members of the Board who have the requisite knowledge that is
commensurate with the complex nature of the banking institution.
Independent, competent and qualified auditors is an essential pre-requisite of good corporate
governance which would achieve a number of important objectives. It would ensure timely
identification of risks and the publication of financial statements which accurately represent
the financial position and performance of the bank. Auditors should understand their duty to
the bank and its stakeholders to exercise due professional care in the conduct of audits. In
this connection, we have, in the recent past, strengthened the relationship of auditors with
the regulator and the company to benefit from each others' capabilities, expertise and
knowledge.
Basel II has attempted to capture all these critical aspects into the new accord. A bank's
own assessment of its capital needs, coupled with the regulator's assessment of the
adequacy of capital, which would encompass all other aspects of its operations, apart from
credit, would ensure adequate capital to insulate the bank against its risk exposure. After all,
managing risk is fast becoming the single most important issue for the regulators as well as
for the institutions that are regulated. Therefore, Basel II is good news and we can only
benefit mutually from its adoption. A roadmap is therefore already drawn up and we hope we
can all commence our journey down this road to reach our goal of a safe and sound banking
system resulting in financial stability which is what we all aspire.
As you are all aware, our banking community is in the process of adopting the standardized
approach within Basel II by 2007. However, the major challenge faced by the banks in the
next few years, are the IT, skills development and training that are required to implement the
more advanced approach which relies heavily on quantitative techniques. It is imperative,
therefore, that banks start getting ready for this eventuality sooner, than later.
Basel II should not be looked at as an exercise in compliance but as an impetus to more
efficient risk management across the banking sector. Its benefits would be seen in the ability
of the financial system, to promote sustainable economic growth which would be beneficial to
the banks, the central bank and to the consumers of banking business. It would naturally
require commitment of substantial capital and human resources from both the banks and the
regulators. We should all work together, therefore, to achieve these goals. This should not
only be the objective of the Central Bank as we are all guardians of financial stability - I trust
this conference will provide an adequate forum for open discussion. Thank you.