BASEL II

Introduction and Background Errol Kruger 7 February 2005

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AGENDA
Banks and banking Basel Committee on Banking Supervision Basel I Is Basel II appropriate for South Africa? Conclusions

Agenda
Banks and banking Basel Committee on Banking Supervision Basel I Is Basel II appropriate for South Africa? Conclusions

Why do we need banks?

Safeguard savings of general public Financial intermediation From surplus econ units to deficit econ units Channel savings and provide credit Bridges preferences [eg. time ] Pooling of funds for large scale projects Payments and settlements system Risk intermediation Conclusion: Banks are very important
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Why should banks be regulated

Banks fail Free entry [Public interest; Fit and proper; Min capital] Banks wish to survive and grow Accordingly, expose themselves to risk Importance of risk management Free exit [Shareholders stand last in line] Avoid systemic risk National good material economic benefits Market failure to be counteracted

Ultimate regulatory goals

To add value to banking system; and financial system; and economy By facilitating stability and soundness efficiency and effectiveness consumer protection Through sound corporate governance best practice risk management best practice disclosure

Strategic imperatives
SARB Mission
The achievement and maintenance of price stability

BSD Mission
To promote the soundness of banks through the effective application of international regulatory and supervisory standards
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South African banking sector

Registered banks 37 Locally controlled: 15 Foreign controlled (subsidiaries): 5 Branches of foreign banks: 15 Mutual banks: 2 Total banking assets: Around R1 484.8 bn
(as at the end of November 2004)

Capital adequacy: 13,2%

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Distribution of total assets of banking sector

Total Assets (as at the end of Nov 2004): R1484.8 bn
November 2004
3.0% 9.0%

88.0% A1 rated banks Local controlled A2 rated banks Foreign controlled A2 rated banks

Key banking sector indicators

November 2003 November % 2004 Growth 1126.9 898.0 122.5 1108.3 1484.8 64,2 3,0 20.3 8.3 13.1 13,2 -18,4 -18,2 -16,2
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Funding related liabilities to the public (Rbn) Non-bank funding (Rbn) Capital and reserves (Rbn) Loans and advances (Rbn) Total assets (Rbn) Efficiency ratio = cost-to-income-ratio (smoothed) (%) Interest margin (%) Gross amount classified as doubtful and loss (Rbn) Market value of security held (Rbn) Specific provisions (Rbn) Capital adequacy (%)

1004.9 734.0 111.1 967.9 1404.8 63,5 3,1 24.9 10.2 15.7 12,6

12,1 22,3 10,2 14,5 5,7

Agenda
Banks and Banking Basel Committee on Banking Supervision Basel I Is Basel II appropriate for South Africa? Conclusions

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Basel Committee on Banking Supervision [BCBS]

Founded By central bank governors of G10 Date: 1974 Focus: Banking supervision Objectives Adequate supervision No internationally active bank should escape supervision Meets 4 times per year Around 30 working groups / task forces Location of secretariat: Basel, Switzerland 12

BCBS
Legal nature: Voluntary association Authority No formal supra-national authority Thus, pronouncements: No legal force Output series of publications Broad supervisory guidelines Statements of best practice Desired outcomes Convergence in approaches Convergence in standards
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Agenda
Banks and Banking Basel Committee on Banking Supervision Basel I Is Basel II appropriate for South Africa? Conclusions

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Basel I Basis is capital

Rationale Foundation for economic growth Buffer against unexpected losses Inadequate capital leads to Disruptions, eg. of payments system Inefficient allocation of capital Note No amount of capital will protect against weak management Even the best management may make mistakes and are exposed to possibility of unexpected 15 losses

Basel I - Achievements
Capital Definition of capital first to be internationally accepted Capital adequacy first international benchmark Regulatory capital adequacy - Accepted soundness indicator Risk management orientation Credit risk: Simple measure Market risk: Simple and advanced measures Simple to apply contributed to its acceptance Outcome: Basel I adopted in over 100 countries
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What changes have occurred since introduction of Basel I?

Globalisation Physical geography not an impediment to movement of money Growth in cross-border trade, finance, investment Technological advances Computing power and storage Networks and communications Financial engineering (development of highly sophisticated/complex products)
17 The above causes precipitated the need for change

Which dimensions of Basel I have been highlighted by foregoing changes?

Backward-looking based on historic information Risk approach Limited risk sensitivity a blunt instrument Not comprehensive Regulatory arbitrage Simplistic and static Does not cater for sophisticated banks Not flexible and dynamic Growing divergence between regulatory and economic capital Did not keep up with market developments 18

Outcomes of developments
Risk Evolving methodologies for measuring and managing New ways to un-bundle and transfer risk Financial derivative instruments Securitisation Data - improvements in technology and telecommunications speed up collection and analysis Operational risk management as new discipline [Quantifying the risk of losses from failure of internal processes and systems versus damages from external disruptions] Cause: Barriers of time and geography have been lowered Effect: Reduced life span of existing competitive strengths 19 Outcome: Tidal wave of structural change

Basel I 1988 Accord

Capital Requirements
Qualifying Capital Risk Exposures Minimum Ratio

Regulatory capital ratio

Qualifying capital Credit risk exposures = 8%

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Minimum regulatory capital ratio

Basel I 1988 Accord plus 1996 additions

Qualifying Capital

Minimum Capital Requirements

Risk Exposures

Minimum Ratio

Regulatory capital ratio

Regulatory capital
RW Credit exposure + Capital for market risk x 12.5

Minimum regulatory capital ratio = 8%

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Basel I
Risk Weight 0% Exposure Sovereign RSA & OECD Intragroup advances to banks RSA Public Sector Bodies Sovereigns in common monetary area Credit Risk Mitigation Collateral cash & gold Guarantees by Sovereign (RSA & OECD) Irrevocable facilities with short maturity Guarantees from RSA Banks & OECD Banks

5% 10%

20%

Public Sector Bodies in RSA, CMA Irrevocable facilities with longer & OECD banks maturity Residential mortgage exposures LTV 80% All other counterparties Guarantees from non-banks All other irrevocable facilities 22

50%

100%

Agenda
Banks and banking Basel Committee on Banking Supervision Basel I Is Basel II appropriate for South Africa? Conclusion

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Realities for SA we have both

Developed component
Th e Di Gr vi e a de t

Developing component
60% of South Africans dont have transactional bank account FinMark Trust Stokvels

International Access to Finance

Risk Management
e-Banking

Information Systems Data warehousing Risk Adjusted Return on Capital

Village Banks Limited telephone & internet Access No exposure ratings

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Is Basel II Appropriate for SA???

Per IMF and World Bank

Avoid adoption at all costs approach Priority is to ensure financial sector safety and soundness by ensuring compliance with B I, BCP, IAS, etc. FSAPs and Article 4 assessments Will not negatively score non-adoption of B II Once a country decides to adopt B II, it will be assessed based on the quality of its adoption plans and its implementation of B II
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Is Basel II for SA?

SA Emerging market Sophisticated financial sector Important regional financial centre Banking is one of the most global industries Physical boundaries have little relevance in the banking industry [money moves anywhere at the click of a button] To play this game you must play by its [international/universal] rules

Outcome: > 100 countries committed to Basel II

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Pre-conditions to Basel II
1) Banking industry developing culture of risk management [Pillar I] 2) Effective supervision exists Compliance with Basel Core Principles for Effective Supervision [Pillar II] 3) Market has clear rules for disclosure and moving to greater transparency [Pillar III]
27 Source: Making diligent preparations for Basel II; Speech by Jaime Caruana at ICBS held in Madrid, 2004 09 22

SAs state of readiness

Area
Legislation Banks Companies Insolvency FICA/FAIS/Etc. Accounting Auditing Corporate governance Risk management Disclosure Payments system Supervision

Status quo
Up to standard Yes Yes (?) Yes Yes IFRS compliant IAS compliant Best practice Best practice Best practice Basel CPSS compliant BCP and B I compliant

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Agenda
Banks and Banking Banking in South Africa Is Basel II appropriate for South Africa Conclusions

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Conclusions
Why must SA change to B II? Events have overtaken Basel I Material economic and other benefits [cost of capital; credit ratings; pursuit of robust institutions and sector] Is SA capable and ready to change to B II? Infrastructural framework is in place Standards and checks and balances OK What are the implications of B II? Improved safety and soundness Improved governance, risk management, etc Forward looking QIS 4 and Economic Impact Study

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The end
Thank you for the opportunity

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