Framework for Dealing with Domestic Systemically Important Banks

ia December 2019 MONETARY BOARI) CENTRAL BANK OF SRI LANKA BANKING ACT DIRECTIONS No. 10 of 2019 FRAMEWORK FOR DEALING WITH DOMESTIC SYSTEMICALLY IMPORTANT BANKS In terms of the powers conferred by Sections 19(7)(a) and76G(7) of the Banking Act No. 30 of 1988, as amended, the Monetary Board has determined a framework for dealing with Domestic Systemically Important Banks (D-SIBs) and Higher Loss Absorbency iiequirements (HLA) as capital surcharge on D-SIBs having regard to the guidelines issued by the Basel Committee on Banking Supervision. This framework attempts to identify the banks whose failure has a larger impact on the financial system due to size, interconnectedness, lack of substitutability and complexity and requires maintaining HLA by such banks.

1. Empowerment 1.1 Scope of Application
2. Capital Surcharge on D-SIBs t.2 2.1 3.1 In terms of Section 102 of the Monetary Law Act, the Monetary Board may from time to time by Order prescribe the minimum capital ratios which the capital of licensed banks shall bear to the total volume of their assets or to any specified category of such assets. In terms of Sections 46(l) and76J(l) of the Banking Act, in order to ensure the soundness of the banking system, the Monetary Board is empowered to issue Directions to all or any licensed bank, regarding the manner in which any aspect of the business of such bank or banks is to be conducted. These Directions shall be applicable to every licensed bank: (i) incorporated in Sri Lanka on a solo and consolidatedbasis; and (ii) branches of banks incorporated or established outside Sri Lanka, on a standalone basis. D-SIBs shall maintain, at all times, the minimum capital surcharge as prescribed in 3.2 below.

J0 December 2019 ,oyh. :ds 'i1ffi6i iz.U, rf_,_fj MONETARY BOARI) CENTRAL BANK OF SRI LANKA BANKING ACT DIRECTIONS No. 10 of 2019 4. Framework 5. Disclosure Requirement J.J 4.7 5.1 3.2 The minimum capital surcharge on D-sIBs are in Table 1 below: Table 1: Minimum Capital Surcharge on D-SIBs Bucket HLA Requirement (CETI as a oh of risk-weighted assets) -) 2.0 2 1.5 I 1.0 The capital surcharge on D-SIBs shall be met with Common Equity Tier 1 (CETI) as defined in Banking Act Directions No. 01 of 2016 of Capital Requirements under Basel III. Framework for Dealing with Domestic systemically rmportant Banks is in Schedule I. For each financial year-end, licensed banks with a Leverage Ratio exposure measure, that exceeds Rs. 400 billion shall comply with the disclosure requirements in Schedule I. fl|, ^-T Dr. Indrajit Coomaraswamy Chairmqn of the Monetary Board and Governor of the Central Bank of Sri Lanka

Banking Act Directions No. 10 of 2019 Framework for Dealing with Systemically Important Banks SCHEDULE I

2 FRAMEWORK FOR DEALING WITH DOMESTIC SYSTEMICALLY IMPORTANT BANKS

1. Introduction 1.1 The Basel Committee on Banking Supervision (BCBS) issued an assessment methodology for global systemically important banks (G-SIBs) and prescribed higher capital surcharge in November 2011. Later in July 2013 and July 2018 the assessment methodology was reviewed and amended. 1.2 Similar to the case of G-SIBs, failure of a large interconnected financial institution that is not significant from an international perspective, may severely impact the domestic financial market and the real economy. Therefore, BCBS issued an extension of the G￾SIB assessment methodology to domestic systemically important banks (D-SIBs) in October 2012. 1.3 Primary objective of the implementation of the D-SIBs framework is D-SIBs to hold higher capital buffers and to provide incentives to reduce their systemic importance on the domestic economy.
2. The D-SIBs Framework 2.1 The D-SIBs framework is based on the 12 principles of BCBS and appropriate national discretion is exercised in selection of indicators to accommodate structural characteristics of the domestic financial system. 2.2 Scope of assessment: all locally incorporated domestic banks, subsidiaries bank branches of foreign banks are included in the assessment based on the criteria specified in 2.4 below. 2.3 D-SIB framework assesses locally incorporated banks on consolidated basis and foreign bank branches will be on a standalone basis. 2.4 Sample of banks: Basel specified criteria on G-SIBs are considered when selecting the sample for D-SIBs as below: (i) 10 largest banks based on Basel III leverage ratio exposure measure; (ii) Banks that were previously designated as D-SIBs in the previous year, if necessary; and (iii) Banks added based on supervisory judgement, if necessary.

3 2.5 The impact of a D-SIB’s failure on the domestic economy in principle is to be assessed having regard to bank-specific factors as below: (i) Size (ii) Interconnectedness (iii) Substitutability/financial institution infrastructure (iv) Complexity 2.6 Details of bank specific factors, individual indicators under each factor and their weights are as follows: Table 01 - Factors Considered in Assessment of D-SIBs 2.7 The indicators are briefly described below. (i) Size (a) The larger the bank, the more difficult it is for its activities to be quickly replaced by other banks and therefore the greater the chance that its distress or failure would cause disruption to the financial markets in which it operates. (b) The distress or failure of a large bank is also more likely to damage confidence of the depositor and the financial system as a whole. (c) The indicator used to measure size is the measure of total exposures used in the Basel III leverage ratio. Category Individual Indicator Category Weighting Size Total exposure 40% Interconnectedness Intra-financial system assets 20% Intra-financial system liabilities Securities outstanding Substitutability / financial institution infrastructure Assets under custody 20% Trading volume Payments activity Complexity Notional amount of derivatives 20% Level 2 assets as reported under Liquidity Coverage Ratio Cross jurisdictional liabilities Cross jurisdictional claims Trading and available for sale (AFS) securities

4 (d) Larger the size of a bank, the greater its market share of critical financial services, greater the cross jurisdictional activities, more interconnected it is to the banking sector and the domestic economy, and therefore it is more difficult to substitute. (e) Considering the systemic importance placed in the “size” indicator and the impact its having on other four indicators, the highest weight of 40% is allocated. (ii) Interconnectedness (a) Financial distress at one bank can materially increase the likelihood of distress at another bank given the network of contractual obligations in which these banks operate. (b) A bank’s systemic impact is likely to be positively related to its interconnectedness vis-à-vis other financial institutions. (c) Three indicators are used to measure interconnectedness: (i) intra-financial system assets; (ii) intra-financial system liabilities; and (iii) securities outstanding. (d) Each indicator is allocated an equal weight of 6.66% and the overall category is weighted at 20%. (iii) Substitutability (a) The systemic impact of a bank’s distress or failure is expected to be negatively related to its degree of substitutability as both a market participant and a client service provider. (b) Three indicators are used to measure substitutability: (i) assets under custody; (ii) payments activity; (iii) trading volume. (c) Underwritten transactions in debt and equity market were not considered since banks do not have an exposure in underwriting based on the data submitted by banks. This indicator will be considered at the next review of the framework which will be performed once in 3 years. (d) Each indicator is allocated an equal weight of 6.66% and the overall category is weighted at 20%. (e) Substitutability is capped at 500 basis points.

5 (iv) Complexity (a) The systemic impact of a bank’s distress is expected to be positively related to its overall complexity including its business, structural and operational complexity. (b) The international impact of a bank’s distress or failure would vary in line with its share of cross-jurisdictional assets and liabilities. The greater a bank’s global reach, the more difficult it is to coordinate its resolution and the more widespread the spillover effects from its failure. Therefore, cross￾jurisdictional activity is included into the complexity. (c) The more complex a bank is, the greater the costs and time needed to resolve. (d) Five indicators are used to measure complexity: (i) notional amount of Over the Counter (OTC) derivatives; (ii) level 2 assets; (iii) trading and available for sale securities; (iv) cross-jurisdictional claims; and (v) cross￾jurisdictional liabilities. (e) Each indicator is allocated an equal weight of 4% and the overall category is weighted at 20%. 2.8 Ancillary Indicators Ancillary indicators are considered relating to specific aspect of the systemic importance of the bank that may not be captured by the indicator based measurement approach alone. These indicators are used to support the judgement overlay. 2.9 Score Calculation (i) Sample of banks are selected for the computation of systemic importance based on the size reported in the exposure measure of the Basel III Leverage Ratio as in 2.4 above. (ii) Data in Annex I is collected from the sample of banks. (iii) To calculate the score for a given indicator, the bank’s reported value for that indicator is divided by the corresponding sample total, and the resulting value is then expressed in basis points by multiplying by 10000. The maximum score for substitutability is capped at 500 basis points. (iv) To calculate the scores for the four bank specific factors, the scores for the indicators that fall within each specific factor are averaged.

6 (v) The final score is produced by averaging the four bank specific factor scores and then rounding to the nearest whole basis point. 2.10 Supervisory Judgment (i) Bank’s score may be adjusted based on supervisory judgment. Supervisory judgment is used to override the indicator-based measurement approach in exceptional cases. (ii) In these exceptional cases, the published bucket does not align with the calculated score. The decision to exercise supervisory judgment generally reflects a variety of quantitative or qualitative factors not captured in the indicators. 2.11 Bucketing Approach (i) Banks that have a score exceeding the regulator determined cut-off level are classified as D-SIBs. (ii) D-SIBs are allocated into 3 buckets with varying HLA requirements in the range of 1.0% to 2.0% as shown in the Table 02 below. (iii) Based on the annual assessment, if necessary, D-SIBs will be allocated into different buckets based on the score and the supervisory judgment. In future, if bucket 3 becomes populated, a new bucket will be added. Table 02 - D-SIBs Bucketing Approach Bucket HLA Requirement (CET1 as a % of risk-weighted assets) 3 2.0 2 1.5 1 1.0 2.12 Interaction with Capital Buffers and Consequences of Breaching the Capital Surcharge on D-SIBs (i) If a D-SIB breaches HLA requirement, it is required to agree on a capital remediation plan to return to compliance over a defined time frame. Until returned to compliance, it is subject to restrictions on discretionary distributions of dividend payout and other restrictions as required by the Regulator. (ii) For a newly identified D-SIB and for a D-SIB that progresses to a bucket requiring a higher HLA requirement, a time frame of 12 months will be permitted

7 to meet the additional requirement. In the event, the bank does not meet the HLA requirement within the time period same restrictions above will be applied. (iii) If on the other hand when D-SIB score falls resulting in a lower HLA requirement, CBSL based on supervisory judgement may decide on a timeline for such bank to be released from its previous HLA requirement. 2.13 Disclosure Requirements (i) For each financial year-end, all banks with a leverage ratio exposure measure, that exceeds Rs. 400 billion are required to publicly disclose 10 high level indicators used in the assessment methodology in their Annual Reports and/or websites as per the format in Annex I. (ii) Banks below this threshold that have been added to the sample owing to supervisory judgment or as a result of being classified as a D-SIB in the previous year would also be required to comply with the disclosure requirements. (iii) Banks should also publicly disclose in their websites if the data used to calculate the D-SIB scores differ from the figures previously disclosed. Banks should disclose the accurate figures in the financial quarter immediately following the finalisation of the D-SIB score calculation. 2.14 Operational Timeline (i) The framework is to be effective immediately and going forward the D-SIBs assessment will be conducted based on below timelines: Table 03 – Timeline for implementation Time Task April Collect data as in Annex I from the selected banks August Assess collected data and identify the list of D-SIBs October Publish the list of D-SIBs that are subject to HLA requirement with the approval of the Monetary Board (ii) The timeline given above will be adhered and practiced annually to decide on the D-SIBs. (iii) The framework of D-SIB assessment will be reviewed once in three years to incorporate any revisions or amendments in accordance with BCBS reviews.

Annex I D-SIBs Assessment Exercise (a) Report data as at 31 December each year, unless otheryise specified. (b) Lmally incorporated banks - report consolidated basis. (c ) Foreign bank branches - solo basis. (d) Financial Institution definition is in accordmce with Direction No. 0l of2016 ofCapital Requirernent under Basel lll

Guide to Fill the Required Information Section Guide Report the total exposure measure used for the leverage ratio. 2a Report all funds deposited with or lent to other flnancial institutions (other financial institutions through out this return are financial institutions outside o1'the consolidated reporting group). Deposits include placements. Lending should include all forms ofterm/revolving lending. overdraft and other extensions ofcredit to flnancial institutions. 2b Report all holdings olsecurities issued by other financial institutions. This includes debentures. trust ceftificates. trading and non-trading shares. 2c This item should include the following: (a) Net positive reverse repurchase agreement exposure, rvhere the value ofthe cash provided exceeds the lair value of the securities received: (b) Net positive repurchase agreement exposure. where the fair value ofthe securities provided exceeds the value of the cash received; (c) Net positive securities lending exposure. where the fair value ofsecurities lent exceeds the value ofcash collateral received (or the fair value ofnon-cash collateral received); and (d) Net positive securities borrowing exposure. where the value ofcash collateral provided (or the fair value ofnon￾cash collateral provided) exceeds the fair value ofsecurities borrowed. 2d Report the sum of "net positive fair value" and "the potential future exposure" fbr OTC derivatives rvith other financial institutions that have a net positive mark to market value. Netting is valid if the criteria in the Direction No. l2of20l8onLeverageRatiounderBasel Illismet.Onlynettingsetsrvithapositivevalueshouldbe reported here. Netting sets where the net result is negative should be repofted in item 3c below. 3a Report an1'funds deposited by or borrowed f'rom other flnancial institutions that are accounted fbr as payables. Do not include any liability arising fiom 4 below. lb This item should include the following: (a) Net negative reverse repurchase agreement exposure. where the fair value ofsecurities received exceeds the value ofthe cash provided. (b) Net negative repurchase agreement exposure. where the value ofthe cash received exceeds the f-air value ofthe securities provided. (c) Net negative securities lending exposure. where the value ofcash collateral received (or the fair value ofnon￾cash collateral received) exceeds the fair value ofsecurities lent. (d) Net negative securities borrowing exposure. where the l'air value of securities borror.ved exceeds the value of cash collateral provided (or the fair value ofnon-cash collateral provided). 3c Report the sum of"net negative fair value" and "the potential future exposure" fbr OTC derivatives u'ith other financial institutions that have a net negative mark to market value. Netting is valid if the criteria in the Direction No. l2of20l8onLeverageRatiounderBasellllismet.Onlynettingsetswithanegativevalueshouldbereported here. Netting sets u'here the net result is positive should be repofted in item 2d above. 4 Report the value ofall outstanding securities that were issued by. or on behalfof. the reporting entity. Accordingly. securities should be repoded regardless ofwhether or not they are held by other tlnancial institutions. Exclude the shares issued. 5 Payments should be reported regardless of purpose. location. or settlement method done during the repofting period . This includes RTGS gross payments. ATM withdrawals. credit/debit card payments. cheque payments. internet banking and mobile banking payments. Only include outgoing payments (i.e. exclude payments received). Do not include intragroup transactions. 6 Report the value ofall assets" including cross-border assets that the reporting group holds as a custodian on behall of customers. including other financial institutions. 7 Include all underwriting (public and private) over the reporting year rvhere the bank rvas obligated to purchase unsold securities. Exclude intragroup and self-led transactions. 8 Number ofshares or contracts ofa security traded by the bank during the reportins year, 9 Reporl the notional amount outstandinp. ot-OTC derivative oositions. l0 Report Level 2 assets unweighted amount reported in Liquidity Coverage Ratio. ll Report financial assets which are recognised under f-air value through other comprehensive income and f'air value through profit or loss. This includes but not limited to debt instruments. equity instruments and derivative instruments. t2 Report the sum ofcross-jurisdictional liabilities. Do not include local liabilities in fbreign currenc)'. Exclude derivatives and intragroup liabilities. 13 R.eport the sum of cross-jurisdictional claims. Do not include local claims in fbreign currency. Exclude derivatives and intragroup liabilities.