Basel 3 – A Practical Look Rules of the Game – Three Distinct Areas of Regulation - PowerPoint Presentation

Basel 3 – A Practical Look Rules of the Game – Three Distinct Areas of Regulation Changing Dynamics: Bank of the Future Association of Professional Bankers, 22 nd 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? 21 November 2017 Presentation title

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

Increasing Coverage of the Basel GuidanceRegulatory 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? 21 November 2017 Presentation title

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

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

The Basel 3 Framework How the components now stack up21 November 2017 Tier I Capital (CET I+ AT I) + Tier II Capital + CCB + DSIB RWA( Credit Risk + Market Risk+ Operational Risk) Capital Adequacy Ratio 14% AT I 1.5% Tier I – 6% CET I 4.5% 4% 2.5% 1.5% Tier II CCB DSIB

The Basel 3 Framework The timelines for the staggered targets 21 November 2017 Minimum Ratios % Basel 2 Basel 3 Jul ’17 Jan ’18 Jan ‘19 Tier I Capital Requirement 5 6 6 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 N/A 0.50 1.000 1.50 Counter Cyclical Buffer N/A As and when required 0-2.5

The Basel 3 Framework The key revisions 21 November 2017 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. Further, CBSL has introduced the following risk weightages for gold backed lending based on the Loan To Value (LTV) ratio. LTV Ratio (%) Risk Weight (%) Less than or equal 70 0 Over 70 and below 100 20 Over 100 100 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. Criteria Basel 2 Basel 3 Maximum Credit Exposure <200 Mn <250 Mn Annual turn over <600 Mn <750 Mn

What are the most common challenges in implementing Basel 3? 21 November 2017 Presentation title

Key ChallengesA look at the main issues across five dimensions 21 November 2017 Missing data and poor data quality Small sample size or lack of “bad” cases Data Lack of standard methodologies for model development Common lack of trust in statistical methodology considering issues with quality data at many banks Methodology Challenges 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 Human Resource

21 November 2017 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 Senior management awareness and endorsement Credit team are concerned about asking customers for additional documents Lack of continuous / on-going support , when there are issues faced in model usage Use Test Challenges Key Challenges A look at the main issues across five dimensions

How does Basel 3 impact capital planning for Banks? 21 November 2017 Presentation title

Basel Capital PlanningCapital optimisation across risk types Risk type 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 PlanningThe denominator: Where do RWA figures come from?

Basel Capital PlanningOptimising RWA on standardised portfolios Missing ratings Matching limits to exposures CCFs – allocation to categoriesCollateral – eligibility for recognitionCredit risk mitigationMaturity calculationsExposure classesRetail / SME, central banks, government agencies Use of short term ratings

Basel Capital PlanningOptimising Probability of Default (PD) in IRB Many choices / options in modelling PDDefinition of defaultDefining data sample – use of external rating agency dataSegmentationCalibration 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 PlanningOptimising 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... SegmentationTypes of averaging – default weighted, exposure weighted, PD weighted etc.Downturn methodologyCalibration 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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