Basel 3 – A Practical Look Rules of the Game – Three Distinct Areas of Regulation Changing Dynamics: Bank of the Future Association of Professional Bankers, 22nd November, 2017

Agenda Why were the Basel 3 regulations needed? What does Basel 3 mean for Banks? What are the most common challenges in implementing Basel 3? How does Basel 3 impact capital planning for Banks? 21 November 2017

Why were the Basel 3 regulations needed? 15 January 2019 Presentation title

Evolution of Regulatory Capital Guidance A look across the changes across time 21 November 2017

Increasing Coverage of the Basel Guidance Regulatory capital by risk factor 21 November 2017

Basel 3 Objectives 21 November 2017

Basel 3 Objectives 21 November 2017

What does Basel 3 mean for Banks? 15 January 2019 Presentation title

The Basel 3 Framework A look at the key components 21 November 2017

The Basel 2 Framework How the components stacked up Tier I Capital+ Tier II Capital Capital Adequacy Ratio + Tier I 5% Tier II 5% RWA( Credit Risk + Market Risk+ Operational Risk) 10% 21 November 2017

The Basel 3 Framework How the components now stack up Tier I Capital (CET I+ AT I)+ Tier II Capital +CCB + DSIB Tier I – 6% Capital Adequacy Ratio AT I 1.5% CET I 4.5% Tier II 4% RWA( Credit Risk + Market Risk+ Operational Risk) CCB 14% 2.5% DSIB 1.5% 21 November 2017

The Basel 3 Framework The timelines for the staggered targets Minimum Ratios % Basel 2 Basel 3 Jul ’17 Jan ’18 Jan ‘19 Tier I Capital Requirement 5 6 Minimum Ratio of Total Capital 10 11.75 12.875 14.00 Capital Conservation Buffer N/A 1.25 1.875 2.50 Capital surcharge for DSIB 0.50 1.000 1.50 Counter Cyclical Buffer As and when required 0-2.5 21 November 2017

The Basel 3 Framework The key revisions Under Basel II all claims on government of Sri Lanka were risk weighted at 0%, under Basel III CBSL has introduced 20% risk weightage for foreign claims on government of Sri Lanka from 01.01.2018. LTV Ratio (%) Risk Weight (%) Less than or equal 70 Over 70 and below 100 20 Over 100 100 Further, CBSL has introduced the following risk weightages for gold backed lending based on the Loan To Value (LTV) ratio. Criteria Basel 2 Basel 3 Maximum Credit Exposure <200 Mn <250 Mn Annual turn over <600 Mn <750 Mn Qualifying criteria for SME exposure Risk weight for SME Exposures Basel 2 - 75% for all SME exposure Basel 3 - 60% for SME exposure secured on immovable property. 75% for other SME exposure. 21 November 2017

What are the most common challenges in implementing Basel 3? 15 January 2019 Presentation title

Key Challenges A look at the main issues across five dimensions Data Missing data and poor data quality Small sample size or lack of “bad” cases Methodology Lack of standard methodologies for model development Common lack of trust in statistical methodology considering issues with quality data at many banks Human Resource Lack of personnel with sufficient knowledge and experience in model development Lack of formally established model development / validation teams which are staffed with these specific objectives 21 November 2017

Key Challenges A look at the main issues across five dimensions Senior management awareness and endorsement Board of Directors Incomplete appreciation of the benefits of risk quantification, and lacks orienting direction to the whole system. Not assigned specific responsibilities to personnel Senior Management: Model deployment is time-consuming, which adversely impacts planned time New models may detect high-risk customers, however, given that traditional criteria may be ignored, this may lead to challenges Credit Analyst Additional responsibilities in model usage and maintenance Use Test Credit team are concerned about asking customers for additional documents Lack of continuous / on-going support, when there are issues faced in model usage 21 November 2017

How does Basel 3 impact capital planning for Banks? 15 January 2019 Presentation title

Basel Capital Planning Capital optimisation across risk types Opportunity Market Risk Limited opportunity – VaR already perceived as low Operational Risk Limited opportunity – AMA models complex and whilst capital may be exaggerated, the cost benefit is not attractive Credit risk Lots of opportunity – many components of RW calculation, subjectivity in models, significant regulatory ambiguity, clear links with business processes, significant percentage of bank capital requirement...

Basel Capital Planning The denominator: Where do RWA figures come from?

Basel Capital Planning Optimising RWA on standardised portfolios Missing ratings Matching limits to exposures CCFs – allocation to categories Collateral – eligibility for recognition Credit risk mitigation Maturity calculations Exposure classes Retail / SME, central banks, government agencies Use of short term ratings

Basel Capital Planning Optimising Probability of Default (PD) in IRB Many choices / options in modelling PD Definition of default Defining data sample – use of external rating agency data Segmentation Calibration approach – PiT / TTC considerations, scalar methodology Treatment of missing fields Use of rating grade mappings and master scales Obligor level or grade level feed into RWA calculator Treatment of missing ratings

Basel Capital Planning Optimising Loss Given Default (LGD) in IRB Many choice / options in modelling LGD Typical components – haircuts, LTV, possession / liquidation roll-rates, time to liquidation, time to write-off, recovery rate... Segmentation Types of averaging – default weighted, exposure weighted, PD weighted etc. Downturn methodology Calibration of components or overall LGD – compounding conservatism Severe outcome in benign period as a proxy for expected outcome in a downturn period –bad proxy

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