Basel III - Impact

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BASEL III & IMPACT ON SAMPATH BANK :

BASEL III & IMPACT ON SAMPATH BANK Group No. 04 - Finance 1

GROUP MEMBERS:

GROUP MEMBERS NAME REGISTRATION NO. Y H C S Yapa 2014/MBA/WE/FIN/33 M G T Priyadarshani 2014/MBA/WE/FIN/23 H D D Chrishantha 2014/MBA/WE/FIN/03 M D S Jayasekera   2014/MBA/WE/FIN/12   2

INTRODUCTION ABOUT THE SAMPATH BANK:

INTRODUCTION ABOUT THE SAMPATH BANK Sampath Bank PLC is a public limited company incorporated in Sri Lanka on 10th March1986, under the Companies Act No. 17 of 1982 and listed on the main board of the Colombo Stock Exchange. Ranked as one of the top-tier banks in the country, Sampath Bank Plc’s asset base crossed the Rs 500 Bn mark for the first time in 2015. Only the 3rd private sector commercial bank to achieve this status, Sampath Bank stands proud as the youngest bank to have reached this landmark. As at 31st December 2015, Sampath Bank PLC recorded a market capitalization value Rs 42,734 Mn , with a base of 17,515 shareholders. 3

INTRODUCTION OF BANK OF INTERNATIONAL SETTLEMENT :

INTRODUCTION OF BANK OF INTERNATIONAL SETTLEMENT 01. Established in 1930 02. The BIS is located in Basel (A city in Switzerland) 03. BIS is an international organization of central banks 04. BIS is a central bank for central banks 05. It is the oldest international financial organization 06. 60 central banks are the member BIS 4

FUNCTIONS AND OBJECTIVES OF (BIS)::

FUNCTIONS AND OBJECTIVES OF (BIS): Functions: Regulates capital adequacy Encourages reserve transparency Banking supervision (provide Basel Committee on Banking Supervision) Provides banking services, but only to central banks Acting as a prime counterparty for central banks in their financial transactions Objectives: To promote information sharing To increase transparency in banking and financial system To minimize the risk in banking and financial system To enhance financial stability 5

SUBCOMMITTEES OF BIS::

SUBCOMMITTEES OF BIS: * The BIS carries out its work through its subcommittees 01. Basel Committee, committee on global financial system (BCBS) 02. Committee of payment and settlement system (CPSS) 03. Irving Fisher Committee (IFC) 04. Financial Stability Institute (FSI) 05. Markets committee etc. 6

BACKGROWND OF BASEL COMMITTEE :

BACKGROWND OF BASEL COMMITTEE The   Basel Committee on Banking Supervision  ( BCBS ) is a committee of Bank for International settlements ( BIS) Established in 1974, by the central bank governors of the Group of Ten G-10 countries. The present Chairman of the Committee is Stefan Ingves , Governor of the central bank of Sweden ( Sveriges Riks bank) The Committee's members as of September 2013: Argentina, Australia, Belgium, Brazil, Canada, China, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, United Kingdom and United States 7

WHY BASEL COMMITTEE WAS FORMED? :

WHY BASEL COMMITTEE WAS FORMED? Default of Herstatt Bank (German) - foreign exchange exposures was three times then its capital- (1974) Default of Franklin National Bank (New York) and- (1972) Disruptions in the international financial markets 8

OBJECTIVE OF THE BCBS :

OBJECTIVE OF THE BCBS To enhance financial stability by improving the quality of banking supervision worldwide. To strengthening the Banks capital improving the quality of capital Strengthening the banks' transparency Improving market discipline Improving banking sector’s ability to absorb shocks 9

HISTORY OF BASEL COMMITTIEES:

HISTORY OF BASEL COMMITTIEES Basel I : the Basel Capital Accord, introduced in 1988 and focuses on Capital adequacy of financial institutions. Basel II : the New Capital Framework, issued in 2004 , focuses on following three main pillars Minimum capital Standard [Minimum CAR or CRAR] Supervisory review and [Review by central Bank CBSL, on time to time] Market discipline, [Review by market, stake holders, customer, share holder, gvt etc ] Basel III: Basel III released in December, 2010 , (implementation till March 31, 2018)"Basel III" is a comprehensive set of reform measures in, regulation , supervision & risk management of the banking sector. 10

BASEL I:

BASEL I 01. Basel I sets a of minimum capital requirements for banks 02. This is also known as the 1988 Basel Accord, and was enforced by law in the Group of Ten (G-10) countries in 1992. 03. Basel I, that is, the 1988 Basel Accord, is primarily focused on credit risk and appropriate risk-weighting of assets 11

BASEL I:

BASEL I 01. Assets of banks were classified and grouped in five categories according to credit risk, 02. C arrying risk weights of 0% (for example cash , home country debt like Treasuries ) 03. 20 % ( securitisations such as mortgage-backed securities (MBS) with the highest AAA rating ) 04. 50 % ( residential mortgages ) 05. 100 % (for example, most corporate debt) 12

BASEL II:

BASEL II Basel II Capital Adequacy Framework Basel II, introduced in June 2004 by the Basel Committee on Banking Supervision based in the Bank for International Settlements, Basel, Switzerland, is the current international standard framework for assessing capital adequacy of banks. This new framework replaces Basel I as the international capital adequacy norm for banks . The key features of Basel II The Basel II capital framework comprises three mutually reinforcing pillars , (1) Minimum capital requirements, (2) Supervisory review process and (3) M arket discipline 13

BASEL II:

BASEL II Pillar 1-The calculation of the minimum capital requirements: The Pillar I aim to align the minimum capital requirement on account of credit risk, market risk and operational risk, more closely with the bank’s actual degree of risk. The options for calculating the capital charge for credit risk are the standardized approach and internal ratings based approaches (IRB ). * The standardized approach is based on external credit ratings while the IRB approach, heavily relies on banks’ internal assessment of the components that define the risk of a credit exposure. The IRB approach, in turn, comprises two different methodologies: the foundation and advanced IRB approaches, depending on the sophistication of risk management systems of the banks. 14

BASEL II:

BASEL II The three options for calculating operational risk, which is a new feature in Basel II, are the basic indicator approach, the standardized approach, and the advanced measurement approach. A similar structure applies for measurement of market risk . Pillar 2-The supervisory review process , A ims to give supervisors more responsibility to verify whether banks have taken account of their entire risk profile and maintain sufficient capital to cover their risks and allows to capture the risks not specifically covered under Pillar I . The additional risks that should be considered by the regulators under Pillar 2 are credit concentration risk, treatment of interest rate risk in the banking book, liquidity risk and strategic and reputation risks . Accordingly, the regulators have the option of prescribe additional capital to mitigate such additional risks. 15

BASEL II:

BASEL II Pillar 3: Market Discipline requires banks to publicly disclose key information regarding their risk exposure, risk appetite and performance with a view to promote market discipline. It is expected that enhanced disclosure and transparency, will allow market participants to better assess the safety and soundness of the respective banks and thus exert stronger market discipline. 16

IMPLEMENTATION OF BASEL III :

IMPLEMENTATION OF BASEL III Basel III" is a comprehensive set of reform measures, developed by the Basel Committee on Banking Supervision, to strengthen the regulation, supervision and risk management of the banking sector Objectives of Basel III improve the banking sector's ability to absorb shocks arising from financial and economic stress, whatever the source improve risk management and governance Strengthen banks' transparency and disclosures. 17

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COMPARISON BETWEEN BASEL II AND III :

COMPARISON BETWEEN BASEL II AND III 19

CAPITAL REQUIREMENT – QUALITY AND QUANTITY:

Increase the Quality of Capital Basel III has tightened the definition of “capital”, thus increasing the quality of capital buffers held by banks. More emphasis on “common equity” as the key risk absorbent in the capital structure . Phasing out of non-standard hybrid type components of Tier1 over 10 years. Tighter treatment of deductions, such as minority interest, investments in financial institutions and deferred tax assets. CAPITAL REQUIREMENT – QUALITY AND QUANTITY 20

CAPITAL REQUIREMENT – QUALITY AND QUANTITY:

Increase the Quantity of Capital Basel III greatly focuses on common equity and the minimum to be raised up to 4.5% of risk weighted assets (RWA) after deductions . Capital conservation buffer comprising of common equity of 2.5% of RWA expects to bring the total common equity to 7% from the present level of 2 %. In addition, a countercyclical capital buffer ranging from 0-2.5% could be imposed by the regulator if credit growth is resulting in an unacceptable build of systematic risk. CAPITAL REQUIREMENT – QUALITY AND QUANTITY 21

CAPITAL REQUIREMENT – QUALITY AND QUANTITY:

Change in the Core Capital & Total Capital CAPITAL REQUIREMENT – QUALITY AND QUANTITY 22

CAPITAL REQUIREMENT – QUALITY AND QUANTITY:

Changes in the Banks Capital Structure Basel III demands the banks to maintain much higher capital buffers compared to traditional capital adequacy levels . Banks will face a significant additional capital requirement and this shortfall will need to be raised as common equity or otherwise by retaining dividends . Proper planning and sufficient time is therefore required for banks to attract new capital, preserve existing capital by managing dividend payouts , etc. Certain banks may also opt for consolidation to meet Basel III requirements which needs time. Banks are likely to clean up their balance sheets as soon as possible . CAPITAL REQUIREMENT – QUALITY AND QUANTITY 23

CAPITAL REQUIREMENT – QUALITY AND QUANTITY:

Capital Position of Sampath Bank Sampath Bank reported a Core Capital Ratio (Tier 1) of 7.90% and Total Capital Adequacy Ratio of 12.26% in 2015. Industry Comparison CAPITAL REQUIREMENT – QUALITY AND QUANTITY Core Capital Ratio (Tier 1) Total Capital Adequacy Ratio Sampath Bank 7.90% 12.26% Commercial Bank 11.55% 14.28% HNB 10.53% 12.70% Seylan Bank 12.24% 12.87% Union Bank 24.40% 23.90% Banking Sector 12.80% 15.80% 24

CAPITAL REQUIREMENT – QUALITY AND QUANTITY:

Capital Requirement for Sampath Bank If the Sampath Bank expects to reach to a Core Capital Ratio ( Tier1 ) of 10.00 %; Additional Capital Required = 39,567 – 31,246 = 8,321 Sampath Bank will be required raise additional equity capital of Rs . 8 Billion with in next 1 to 1.5 years to fulfill the existing gap in the Tier 1 capital requirement. CAPITAL REQUIREMENT – QUALITY AND QUANTITY Current Level Expected Level Core Capital Ratio = Core Capital (Tier 1) x 100 31,246 x 100 39,567 x 100 Total Risk-weighted Assets 395,670 395,670 7.90% 10.00% 25

CAPITAL REQUIREMENT – QUALITY AND QUANTITY:

Challenges for Sampath Bank on raising new Capital T o raise additional equity capital of around Rs . 8 Bn , Sampath Bank could go for, Public Offering Rights Issues Since capital requirement is relatively higher Bank may raise the capital in two steps during the next 1 to 1.5 years’ time . Challenge would arise based on the prevailing equity market condition in the country. All Share Price Index (ASPI) has bottomed out over the past few months. Current level of ASPI is 6,400 is lowest since the end of civil war and the index has even reached to levels of 8,500 during the period from 2009-2016 CAPITAL REQUIREMENT – QUALITY AND QUANTITY 26

CAPITAL REQUIREMENT – QUALITY AND QUANTITY:

Challenges for Sampath Bank on raising new Capital Stability of the equity market would be vulnerable with possible increase US Federal Rates where investors in the emerging markets will move to more developed markets and Colombo Stock Exchange will face more pressure with the when foreign investors move out of the market . These adverse market conditions would affect planned raising of equity capital for Sampath Bank. Situation where Bank could not collect the required amount of funds after it decides to enter the equity market may lead to a huge reputation risk as well established bank in the country . Therefore market sentiment is not suitable to raise equity capital for the Sampath Bank. This would put pressure on the Bank to maintain capital requirement of Basel III. CAPITAL REQUIREMENT – QUALITY AND QUANTITY 27

LIQUIDITY STANDARDS:

Liquidity Coverage Ratio (LCR) LCR measures the short term resilience of a bank under significant liquidity stress . This ratio aims to ensure banks maintain a sufficient level of high quality liquid assets to counteract funding outflows and survive up to 30 days under a liquidity crisis. Banks may need to hold low yielding assets such as government securities to meet the LCR . LCR = x100 Central Bank of Sri Lanka issued the directions for the implementation of Liquidity Coverage Ratio for Licensed Commercial Banks and Specialised Banks. Commencing from 1 April 2015, every Banks shall maintain LCR as prescribed below ,   LIQUIDITY STANDARDS Effective Date 1st April 2015 1st January 2016 1st January 2017 1st January 2018 1st January 2019 onwards Minimum % Requirement 60% 70% 80% 90% 100% 28

LIQUIDITY STANDARDS:

Liquidity Position of Sampath Bank Sampath Bank reported a Liquidity Coverage Ratio (LCR) 85% in end of 2015 which is well below the close peers such as Commercial Bank reported 360% and HNB reported 127%. Even though the LCR of Sampath Bank meets the regulatory level of 70% it should reach to the level of 100% by the beginning of 2019. To reach at least to the minimal level of 100% Sampath Bank may need to hold low yielding assets such as government securities to meet the LCR which will have negative impact on profitability. LIQUIDITY STANDARDS 29

LIQUIDITY STANDARDS:

Net Stable Funding Ratio (NSFR ) The net stable funding ratio (NSFR) measures the longer term resilience (up to one year) of a bank’s funding risk profile to ensure that they support their asset growth using stable, long term funding sources . NSFR intends encouraging and incentivising the banks to have stable funding to reduce dependency on short term funding sources . Banks have to maintain stable funding sources such as wholesale and corporate deposits with maturities grater than one year, which are less likely to suffer from sudden withdrawals, rather than short term funding such as interbank borrowings . These deposits are having limited demand in the market and likely to lead to higher funding cost.   LIQUIDITY STANDARDS 30

IMPACT OF BASEL III FOR PROFITABILITY:

Studies have suggested that internationally, Basel III requirements will have a substantial impact on profitability One such study conducted by McKinsey & Company suggest that all other things being equal, Basel III would reduce return on equity (ROE) for the average bank by about 4 percentage points in Europe and about 3 percentage points in the United States. 31 IMPACT OF BASEL III FOR PROFITABILITY

HOW BASEL III CAN AFFECT PROFITABILITY OF A BANK:

Increase of Minimum Common Equity Tier I and Minimum Total Capital including conservation buffer, - Increase cost of Funding ( Approx 8.0 Bn ) Need to reorganize and deal with regulatory reform will put pressure on margins and operating capacity 32 HOW BASEL III CAN AFFECT PROFITABILITY OF A BANK

HOW BASEL III CAN AFFECT PROFITABILITY OF A BANK:

Reduced lending capacity Suppose , a local private bank has ROE of 15% and interest paid on non-equity elements of capital is 10%. Further, suppose that the equity to RWAs ratio of the bank is 6%. Now if the bank is required to maintain an additional 1% equity, the weighted average cost of funds would rise by 5 basis points only. If the equity capital required rises by 2%, the increase in lending rate to pass on the full increase in cost of capital to borrowers would be 10 basis points. 33 HOW BASEL III CAN AFFECT PROFITABILITY OF A BANK

PROFITABILITY OF SAMPATH BANK IN 2015/16:

DuPont analysis tells us that ROE is affected by three things: - Operating efficiency, which is measured by profit margin - Asset use efficiency, which is measured by total asset turnover - Financial leverage, which is measured by the equity multiplier Hence ROE can be calculated as follows. ROE = Profit Margin (Profit/Sales) * Total Asset Turnover (Sales/Assets) * Equity Multiplier (Assets/Equity) 34 PROFITABILITY OF SAMPATH BANK IN 2015/16

PROFITABILITY OF SAMPATH BANK IN 2015/16:

F/Y 2015/16 Rs. Mn Profit 6,134.00 Sales 47,032.00 Total Assets 525,277.00 Equity 33,019.00 Profit Margin 13.04% Total Asset Turnover 8.95% Equity Multiplier 15.91 ROE 18.58% 35 PROFITABILITY OF SAMPATH BANK IN 2015/16

PROFITABILITY OF SAMPATH BANK IN 2015/16:

36 PROFITABILITY OF SAMPATH BANK IN 2015/16 F/Y 2015/16 Rs. Mn (%) on Total Assets Net Interest 17,402.00 0.0331 Overheads 13,339.00 0.0254 Credit Losses 944.00 0.0018 Taxes 2,967.00 0.0056 Costs 17,250.00 0.0328 Net Profit (Loss) 152.00 0.0003 Other Income 5,421.00 0.0103 Profit 5,573.00 0.0106 ROA 1.06% ROE 18.58%

MAJOR CHALLENGE TO SAMPATH BANK:

37 MAJOR CHALLENGE TO SAMPATH BANK Need to raise Rs . 8 bn within 1 – 1.5 years Due to regulatory reforms investor returns will likely to decrease Increase of retained earnings will decrease dividend payments Increase cost of funds will reduce lending capacity (Spread of Sampath Bank is 3.98%)

CONCLUSION:

Overall these impacts to bank’s liquidity and profitability will affect the whole banking system of Sri Lanka, especially banks with low capital such as Sampath Bank, PABC etc. In order to face these challenges banks and financial institutions will have to consider about, - Balance Sheet Re-structuring - Business Model Adjustments 38 CONCLUSION

THANK YOU!:

39 THANK YOU!

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