What you need to know about Basel III and Sri Lankan banks

New capital requirements for banks become effective from June 2017. Nandika Buddhipala, chief financial officer of listed Commercial Bank, takes us through some of the changes and their impacts

What is Basel III?
The Basel Committee on Banking Supervision was established in 1974 to contain global banking risks by formulating guidelines and regulations relating to credit, capital, markets and operations. Its first accord, Basel I, was issued in 1988 and updated in 2004 with Basel II.

Basel III was issued in the aftermath of the global financial crisis in 2008, with tighter regulations and requirements around capital adequacy, leverage, liquidity and funding to ensure that banks maintain sufficient capital to meet financial obligations and absorb unexpected losses.

Sri Lanka is implementing capital adequacy requirements conforming to Basel III in June 2017, setting targets over the next two years.However, the process started much earlier.

How is Sri Lanka rolling out Basel III?
Basel III will be in effect from June 2017, but there aren’t any overnight changes. The Central Bank introduced the Internal Capital Adequacy Assessment Process in 2013, which facilitated the introduction of Basel III.

Standards such as Common Equity Tier I, Capital Conservation Buffer and Capital Surcharge for Domestic Systemically Important Banks will gradually come into effect between June 2017 and January 2019.

Common Equity Tier I is a minimum equity capital requirement, and the Capital Conservation Buffer will require banks to build additional equity capital to back lending growth. The Capital Surcharge for Domestic Systemically Important Banks results in further equity capital for large banks.

What are the main changes?
The Minimum Tier I Capital Adequacy Ratio, which measures the financial health of a bank by comparing its capital to its assets adjusted for risk, is currently at 5% for all banks. The ratio will be lifted to 7.25% for banks with assets less than Rs500 billion by June 2017, and include new equity capital requirements. It will increase further in two stages to 8.5% by 2019.

Raising additional capital for lending growth can be challenging in the absence of limited options to raise Additional Tier I capital in Sri Lanka.

Banks with assets over Rs500 billion will see the ratio increase to 7.75% by June 2017 and 10% by 2019. The Basel III Leverage Ratio, which measures how a bank’s capital base compares with its assets, will be implemented from January 2018, requiring leverage ratios to be maintained above 3% and above 4% for large banks with assets over Rs500 billion.

The Liquidity Coverage Ratio will reach 100% by January 2019. This ratio specifies the amount of liquid assets banks must maintain to meet immediate obligations like deposits.

What will these changes mean?
Basel III is a comparatively new regulation here and not fully implemented to see the impact. However, some insights can be drawn from the experiences of banks in advanced markets.

Some argue that Basel III is turning banks into public utilities. Liquidity and funding requirements are challenging banks’ traditional business models and profitability. The new rules restrict banks from maximizing margins from maturity mismatches, borrowing short term (including deposits) to lend long term. Lending and assigning risks are restricted by tighter leverage and capital requirements. As a result, banking shareholder returns in some markets have fallen to 8-10% from around 15%, and are now comparable to ROEs of public utilities like gas and electric companies.

Sri Lankan banks may not have this problem given that most banks here have maintained solid capital adequacy ratios around 10% even before Basel III.

However, the new liquidity and funding requirements will restrict a bank’s ability to make profits by increasing spreads from maturity mismatches, so banks will have to shift strategy.

Raising additional capital for lending growth can be challenging in the absence of limited options to raise Additional Tier I capital in Sri Lanka. The equity market’s small size is also a challenge—the combined market cap of listed companies is nearly 25% of GDP, whereas it’s more than 70% in India and 88% in Thailand. Furthermore, convertible structures to claim Additional Tier I Capital are not common in Sri Lanka. However, this will change as the economy develops, market earnings improve and more companies list – the capital market will be an important place to raise capital. Also, banks that manage their affairs well and deliver decent returns will always attract investors.

Disclosure requirements will increase with Basel III, and this requires considerable investments in data architecture and IT infrastructure in time to come.

How will borrowers be affected?
Usually, lending interest rates should rise as banks’ cost of capital increases. However, this may not be the case because Basel III has the least impact on interest rates increasing or reducing compared to more important drivers like monetary policy, taxation, demand for credit, competition, the macroeconomic environment and global market volatility.