CB relaxes capital rules to shield banks from economic fallout

• Central Bank revives pandemic time policy playbook with more intensity

The Central Bank this week announced a series of measures to minimise the impact on banks’ capital profiles, potentially stemming from the far-reaching consequences of the economic shock, which reverberate through every aspect of businesses and households.  

In a new set of rules to alleviate the possible pressure on banks’ capital, the Central Bank has allowed licensed commercial and specialised banks to draw down from their Capital Conservation Buffers (CCB) up to 2.5 percent, subject to conditions. 

Further, banks were also given time till December 2023 to meet their minimum capital requirements, extending the current deadline from December 2022. 

This is a repetition of the same playbook exercised by the Central Bank two years ago, though with more intensity to shield the banking sector from a potential liquidity and capital erosion.

 In April 2020, banks were given the option to draw down 100 and 50 basis points each from the CCB, based on their domestic systemically important status and gave two years through December 2022 to meet their minimum capital levels. But, the situation between then and now is different as the economy then had relatively more muscle to withstand the virus-related lockdown shock for a limited period. However, now the economy has weakened beyond redemption as it went through a hard landing in March, due to reasons both man-made and otherwise, such as inflation and the commodities crunch sweeping across globally due to two-years of lockdowns and Russian invasion of Ukraine. 

This time, the Central Bank linked the CCB drawdown to banks’ earnings retention ratio, to make an inverse relationship between the retention ratio and the CCB maintenance ratio. For instance, those banks which retain zero earnings will have to continuously maintain the full 2.5 percent CCB ratio while those which retain 100 percent of their profits could draw down till the CCB falls between 0 to 0.625. The CCB is an additional capital buffer over an above banks; typical Tier I and Tier II capital levels, necessitated under BASEL III rules with the prime intention of promoting capital building during good times to be utilised during stressed times. However, banks will have to submit a 3-year capital augmentation plan to the Central Bank within 21 days of the drawdown to rebuild the CCB. 
Meanwhile, those banks which will take time till December 2023 to meet their minimum capital levels are also required to submit capital augmentation plans, including merger plans on or before the last day of this year. 

They are also barred from distributing dividends and repatriating profits until minimum capital is met. In a further measure to alleviate the potential impact on capital adequacy ratios, the Central Bank let banks to recognise the overnight mark to market losses on the government securities portfolio denominated in LKR, on staggered basis through the second quarter of 2024. 

Banks may have to book hefty fair value losses on their gilts holdings after the policy rates were raised sharply on April 8 to fight inflation as well as to alleviate the pressure on the Balance of Payment. 

According to the proposed loss absorption schedule by the Central Bank, banks are required to absorb one third of the full loss in the incumbent quarter, going up to 2 thirds a year later and up to 100 percent by the second quarter of 2024. However, such banks which opt for a staggered loss absorption schedule cannot pay dividend nor repatriate profits and must also refrain to the extent possible from incurring non-essential capital expenditure until the entire mark to market loss is fully recognised in the capital adequacy computation. 

In another measure, banks have also been given the option to move to the Standardised Approach or the Alternative Standardised Approach to compute their risk weighted assets for operational risk until December 2023, subject to approval from the Director of Bank Supervision. 

Assets which are mostly composed of loans, advances and other financial investments in a bank are risk weighted according to credit, markets and operational risks for gauging the banks’ capital adequacy in relation to their assets, and the latter measures the risk of the operational aspects of engaging in the day-to-day banking business.