conclusion about the binding nature and enforceability of the documents. Banks should
also undertake such further review as necessary to ensure continuing enforceability.
6.6.1.5  T reatment of Pools of CRM Techniques:  In case where a bank has multiple CRM
techniques covering a single exposure ( e.g.: a bank has both collateral and guarantee
partially covering an exposure), the bank will be required to subdivide the exposure into
portions covered by each type of CRM technique ( e.g.: portion covered by collateral,
portion covered by guarantee) and the risk-weighted assets of each portion must be
calculated separately. When credit protection provided by a single protection provider
has differing maturities, they must be subdivided into separate protection as well.
6.6.2  CRM T echniques
6.6.2.1  Collateralised T ransactions: A collateralised transaction is one in which:
• banks have a credit exposure or potential credit exposure; and
• that credit exposure or potential credit exposure is hedged in whole or in part by
collateral posted by a counterpart or by a third party on behalf of the counterpart.
6.6.2.1.1  The Simple Approach will be Followed in Computing the Effects of
CRM
 (i) In the simple approach, the portions of claims collateralised by the market
value of recognised collateral receive the risk weight applicable to the
collateral instrument. The risk weight on the collateralised portion will
be subject to a floor of 20 per cent. The remainder of the claim should
be assigned to the risk weight appropriate to the counterparty.
 (ii) Mismatches in the maturity of the underlying exposure and collateral will
not be allowed, i.e., the collateral must be pledged for at least the life
of the exposure.
6.6.2.1.2  Risk W eights
 (i) The 20 per cent floor for the risk weight on a collateralised transaction
will not be applied and 0 per cent risk weight can be applied provided
the exposure and the collateral are denominated in the same currency,


the exposure and the collateral are denominated in the same currency,
and either:


Directions, Determinations, and Circulars issued to Licensed Specialised Banks  39
 (a) the collateral is cash on deposit and gold or
 (b) the collateral is in the form of Government securities or
 (c) the collateral is in the form provident fund balances.
6.6.2.1.3  Minimum Conditions
 (i) Legal Certainty: as described in paragraph 6.6.1.4
 (ii) Ability to Liquidate:  The bank should have the right to liquidate or take
legal possession of it, in a timely manner, in the event of the default,
insolvency or bankruptcy (or one or more otherwise-defined credit
events set out in the transaction documentation) of the counterparty (and,
where applicable, of the custodian holding the collateral). Furthermore
banks must take all steps necessary to fulfil those requirements under
the law applicable to the bank’s interest in the collateral for obtaining
and maintaining an enforceable security interest.
 (iii) Material Correlation:  In order for collateral to provide protection, the
credit quality of the counterparty and the value of the collateral must
not have a material positive correlation. For example, securities issued
by the counter party or by any related group entity - would provide little
protection and so would be ineligible.
 (iv) Recovery Procedures:  Banks must have clear and robust procedures for
the timely liquidation of collateral to ensure that any legal conditions
required for declaring the default of the counter party and liquidating the
collateral are observed, and that collateral can be liquidated promptly.
Where the collateral is held by a custodian, banks must take reasonable
steps to ensure that the custodian segregates the collateral from its own
assets.
6.6.2.1.4  Eligible Financial Collateral
 The following collateral instruments are eligible for recognition in the simple
approach:
 (i) Cash (as well as certificates of deposit or comparable instruments,
including fixed deposit receipts, issued by the lending bank) on deposit


including fixed deposit receipts, issued by the lending bank) on deposit
with the bank, which is incurring the counterparty exposure.
 (ii) Gold: Gold would include both bullion and jewellery .
 (iii) GOSL  securities
 (iv) Provident fund balances
 (v) Debt securities rated by a recognized ECAI where these are either
– At  least BB- when issued by sovereigns or PSEs that have been
recognized, or
– At least BBB- when issued by other entities (including banks), or
– At least A-3//P-3 for short-term debt instruments.
 (vi) Debt securities not rated by a ECAI where these are:
– Issued by a bank; and
– Listed on a recognized exchange, and
– Classified as senior debt
– Other securities, specified by the Central Bank.
 (vii) Equities those are included in the Milanka index, subject to a discount
of 25 per cent on the market value.


40 Directions, Determinations, and Circulars issued to Licensed Specialised Banks
6.6.2.2  On-Balance Sheet Netting - Where a bank,
6.6.2.2.1  has a well-founded legal basis for concluding that the netting or of fsetting
agreement is enforceable in each relevant jurisdiction regardless of whether
the counterpart is insolvent or bankrupt;
6.6.2.2.2  is able at any time to determine those assets (loans) and liabilities (deposits)
with the same counterpart that are subject to the netting agreement;
6.6.2.2.3  monitors and controls its roll-of f risks; and
6.6.2.2.4  monitors and controls the relevant exposures on a net basis
6.6.2.2.5  it may use the net exposure of loans and deposits as the basis for its capital
adequacy computation.
6.6.2.3  Guarantees
6.6.2.3.1  Guaranteed Transactions: Where guarantees are direct, explicit, irrevocable
and unconditional, banks may take account of such credit protection in
calculating capital requirements.
6.6.2.3.2  Minimum Conditions
 (i) A  guarantee (or counter-guarantee) must represent a direct claim on
the protection provider and must be explicitly referenced to specific
exposures or a pool of exposures, so that the extent of the cover is
clearly defined and incontrovertible.
 (ii) Other than non-payment by a protection purchaser of money due in
respect of the credit protection contract it must be irrevocable; there
must be no clause in the contract that would increase the effective
cost of cover as a result of deteriorating credit quality in the hedged
exposure.
 (iii) It must also be unconditional; there should be no clause in the protection
contract outside the control of the bank that could prevent the
protection provider from being obliged to pay out in a timely manner
in the event that the original counterpart fails to make the payment(s)
due.
 (iv) In addition to the legal certainty requirements above, the following
conditions must also be satisfied:


conditions must also be satisfied:
– On the qualifying default or non-payment of the counterpart, the
bank may in a timely manner pursue the guarantor for any monies
outstanding under the documentation governing the transaction.
The guarantor may make one lump sum payment of all monies
under such documentation to the bank, or the guarantor may
assume the future payment obligations of the counterpart covered
by the guarantee. The bank must have the right to receive any such
payments from the guarantor without first having to take legal
actions in order to pursue the counterpart for payment.
– The guarantee is an explicitly documented obligation assumed by
the guarantor.
– Except as noted in the following sentence, the guarantee covers all
types of payments the underlying obligor is expected to make under
the documentation governing the transaction, for example notional
amount, margin payments, etc.
– Where a guarantee covers payment of principal only , interests
and other uncovered payments should be treated as an unsecured
amount.


Directions, Determinations, and Circulars issued to Licensed Specialised Banks  41
6.6.2.3.3  Eligible Guarantors (counter -guarantors):  Credit protection given by the
following entities will be recognised: sovereign entities, PSEs and other
entities with a risk weight of 20 per cent or better and a lower risk weight than
the counterpart.
6.6.2.3.4  Risk W eights
 The protected portion is assigned the risk weight of the protection provider .
The uncovered portion of the exposure is assigned the risk weight of the
underlying counterpart.
 (i) A  zero risk weight will be applied to that portion of loans guaranteed by
GOSL and CBSL.
 (ii) The portion of exposures guaranteed by the Sri Lanka Export Credit
Insurance Corporation (SLECIC) will receive a 50 per cent risk
weight.
6.6.3  Specific Instructions for  completion Part III ( c)
6.6.3.1  T otal CRM Exposure
 (WBRC 1 1.3.3.0.0.0)
 Total exposure of collateralised transactions and other CRM techniques. All exposures
should be reported net of specific provisions and interest in suspense that has been
charged to the respective counterparty account. Exposures which are reported in this
part under CRM should not be reported in the other parts of the capital adequacy return.
The amount is automatically shown on web-based return.
 The amount must agree with the sum of items 6.6.3.1.1 and 6.6.3.1.2.
 (WBRC 1 1.3.3.1.0.0 + 11.3.3.2.0.0)
6.6.3.1.1  Collateralised T ransactions
 (WBRC 1 1.3.3.1.0.0)
 The sum of collateralised retail exposures and collateralised other exposures.
The amount must agree to sum of items (i ) and (ii). The amount is automatically
shown on web-based return.
 (WBRC 1 1.3.3.1.1.0 + 11.3.3.1.2.0)
 (i) Retail Exposur es
  (WBRC 1 1.3.3.1.1.0)
  The total amount of retail exposures against the collateral instruments
which are eligible for recognition in the simple approach as specified in
paragraph 6.6.2.1.4. The amount is automatically shown on web-based
return.


paragraph 6.6.2.1.4. The amount is automatically shown on web-based
return.
  (WBRC 1 1.3.3.1.1.1 to 11.3.3.1.1.7)
 (ii) Other  Exposures
  (WBRC 1 1.3.3.1.2.0)
  The total amount of other exposures against the collateral instruments
which are eligible for recognition in the simple approach as specified in
paragraph 6.6.2.1.4. The amount is automatically shown on web-based
return.
  (WBRC 1 1.3.3.1.2.1 to 11.3.3.1.2.7)
6.6.3.1.2  Other  CRM Techniques
 (WBRC 1 1.3.3.2.0.0)
 The total amount of exposures against the other CRM techniques (other


42 Directions, Determinations, and Circulars issued to Licensed Specialised Banks
than collateralized transactions). The amount is automatically shown on
web-based return.
 (WBRC 1 1.3.3.2.1.0 + 11.3.3.2.2.0)
 (i) On-Balance Sheet Netting
  (WBRC 1 1.3.3.2.1.0)
  T he total amount of exposures against the on-balance sheet netting
should be reported in line with the instructions given in the items under
paragraph 6.6.2.2 above.
 (ii) Guarantees
  (WBRC 1 1.3.3.2.2.0)
  The total amount of exposures against the guarantees should be reported
in line with the instructions given in the items under paragraph 6.6.2.3
above.
6.7 Part IV  – Computation of Risk-weighted Amount for Market Risk
6.7.1  Capital Charge for  Market Risk  - Market risk is defined as the risk of losses in on-balance sheet
and off balance sheet positions arising from movements in market prices. The market risk subject
to the capital charge requirements are:
6.7.1.1  The risks pertaining to interest rate related instruments  in the trading book
6.7.1.2  The risks pertaining to equities in the trading book.
6.7.1.3  The risks pertaining to foreign exchange position  (including gold positions) throughout
the bank.
6.7.2  Scope and Coverage of Capital Charge for  Market Risks
6.7.2.1  This involves computing capital char ges for interest rate related instruments in the
trading book, equities in the trading book and foreign exchange risk (including gold
positions) throughout the bank. For the purpose of this section, the trading book and
foreign exchange position will include the following:
6.7.2.1.1  Se curities classified in the ‘Trading Account’ in terms of the direction on
Prudential Norms for Classification, Valuation and Operation of the Bank’s
Investment Portfolio issued by the CBSL dated 01 March 2006.
6.7.2.1.2  Open gold positions
6.7.2.1.3  Open foreign exchange positions.
6.7.3  Measur ement of Capital Charge for Interest Rate Risk


6.7.3  Measur ement of Capital Charge for Interest Rate Risk
6.7.3.1  This section describes the framework for measuring the risk of holding or taking
positions in debt securities and other interest rate related instruments denominated in
Sri Lanka Rupees as well as foreign currencies  in the trading book.
6.7.3.2  The capital char ge for interest rate related instruments would apply to the current market
value of these items in the bank’s trading book. Since banks are required to maintain
capital for market risk on an ongoing basis, they are required to mark-to-market their
trading positions on a daily basis. The current market value will be determined according
to the Direction on Prudential Norms for Classification, Valuation and Operation of the
bank’s investment portfolio issued by CBSL.
6.7.3.3  The minimum capit al requirement is expressed in terms of two separately calculated
charges, “specific risk”  charge for each security, which is akin to the conventional
capital charge for credit risk, both for short and long positions, and “general market
risk”  charge for interest rate risk in the portfolio, where long and short positions in
different securities or instruments can be offset.


Directions, Determinations, and Circulars issued to Licensed Specialised Banks  43
6.7.3.3.1  Specific Risk
 (i) The capital char ge for specific risk is designed to protect against an
adverse movement in the price of an individual security owing to
factors related to the individual issuer.
 (ii) The risk charges to be used in the Computation of specific risk will be
as follows:
 (iii) Specific risk char ge for government securities and central banks:
 (a) Government securities issued by the GOSL  and securities issued
by the CBSL will be subject to a risk charge of 0 per cent.
 (b) Securities issued by a foreign government or by a foreign central
bank will be subject to a risk charge based on the credit rating as
indicated in the following table:
Table 15
Specific Risk Charge for Securities Issued by Foreign
Governments/Central Banks
Sovereign Rate Capital Charge for Specific Risk
AAA to AA- 0%
A+ to BBB- 0.25% (residual term to final maturity 6
months or less)
1% (residual term to final maturity greater
than 6 and up to and including 24 months)
1.60% (residual term to final maturity
exceeding 24 months)
All others 10.00%
 (iv) The ‘Qualifying’  category for Corporate entities:
 (a) Corporate entities (Local) will be given a risk char ge for specific
market risk based on their ratings as indicated in the table
below:
Table 16
Specific Risk Charge for Corporates
Sovereign Rate Capital Charge for Specific Risk
AAA to AA- 0.25%
A+ to BBB- 1.00% (residual term to final maturity 6
months or less)
1.60% (residual term to final maturity
greater than 6 and up to and including 24
months)
10.00% (residual term to final maturity
exceeding 24 months)
All others 10.00%
 (b) The specific risk char ge for foreign corporates would be one
notch less favourable than the risk charge applied to the local
corporates.


44 Directions, Determinations, and Circulars issued to Licensed Specialised Banks
 (v) ‘Public sector entities’ should be treated like corporate entities unless
they are backed by an explicit Treasury guarantee, which warrants a
risk charge of 0 per cent.
 (vi) The ‘ Other’ category:
  A  capital charge of 10 per cent will apply to all other types of
exposures.
 (vii) Banks may rely upon the ratings assigned by the ECAIs recognised by
CBSL (See paragraph 6.4.2) for the purpose of ratings referred in the
table 15 and 16 above.
6.7.3.3.2  General Market Risk
 The capital requirements for general market risk are designed to capture the
risk of loss arising from changes in market interest rates. The capital charge
is the sum of four components:
 (i) the net short or long position in the whole trading book;
 (ii) a  smaller proportion of the matched positions in each time-band
(the “vertical disallowance”);
 (iii) a lar ger proportion of the matched positions across different timebands
(the “horizontal disallowance”), and
 (iv) a net char ge for positions in options, where appropriate.
Note – Components (ii), (iii) and (iv) will not apply at present.
6.7.3.4  It has been decided to allow banks to initially adopt the Standardised Measurement
Method , as Sri Lankan banks are still at a nascent stage of developing internal risk
management models. There are two principal methods of measuring market risk under
the Standardised Measurement Method, i.e., a ‘maturity’ method and a ‘duration’
method. It has been decided to adopt the ‘duration’ method to arrive at the capital charge.
Accordingly, banks are required to measure the general market risk charge by calculating
the price sensitivity of each instrument in the trading book separately and adding the
resulting price sensitivities based on a maturity ladder, subject to disallowances if any.
6.7.3.5  The steps for the computation are as follows:


6.7.3.5  The steps for the computation are as follows:
6.7.3.5.1  Calculate the price sensitivity of each instrument in terms of a change in
interest rates between 1.2 and 2.0 percentage points, depending on the
maturity of the instrument (see Table 17);
6.7.3.5.2  slot the resulting price sensitivities into a duration based maturity ladder with
the fifteen time bands as set out in Table 17;
6.7.3.5.3  subject long and short positions in each time band to a 5 per cent vertical
disallowance designed to capture basis risk; and
6.7.3.5.4  carry forward the net positions in each time-band for horizontal of fsetting
subject to the disallowances set out in Table 18.
Note – Steps (6.7.3.5.2) to (6.7.3.5.4) are not required at present since components ii, iii
and iv under paragraph 6.7.3.3.2 above are currently not applicable.


Directions, Determinations, and Circulars issued to Licensed Specialised Banks  45
Table 17
Duration Method – Time Bands and Assumed Changes in Yield
Time Bands Assumed Change in Yield
Maturity Zone 1
1 month or less 2.00
Over 1 month to 3 months 2.00
Over 3 months to 6 months 2.00
Over 6 months to 12 months 2.00
Maturity Zone 2
Over 1.0 year to 1.9 years 1.80
Over 1.9 years to 2.8 years 1.60
Over 2.8 years to 3.6 years 1.50
Maturity Zone 3
Over 3.6 years to 4.3 years 1.50
Over 4.3 years to 5.7 years 1.40
Over 5.7 years to 7.3 years 1.30
Over 7.3 years to 9.3 years 1.20
Over 9.3 years to 10.6 years 1.20
Over 10.6 years to 12 years 1.20
Over 12 years to 20 years 1.20
Over 20 years 1.20
Table 18
Horizontal Disallowances
Maturity Zones Time BandWithin
the zonesBetween
adjacent zonesBetween zones
1 and 3
Maturity Zone 11 month or less
40%
40%
 100%over 1 month to 3 months
over 3 months to 6 months
over 6 months to 12 months
Maturity Zone 2Over 1.0 year to 1.9 years
30% Over 1.9 years to 2.8 years
Over 2.8 years to 3.6 years
Maturity Zone 3Over 3.6 years to 4.3 years
30% 40%Over 4.3 years to 5.7 years
Over 5.7 years to 7.3 years
Over 7.3 years to 9.3 years
Over 9.3 years to 10.6 years
Over 10.6 years to 12 years
Over 12 years to 20 years
Over 20 years


46 Directions, Determinations, and Circulars issued to Licensed Specialised Banks
6.7.4  Measur ement of Capital Charge for Equities
6.7.4.1  The minimum capital requirement to cover the risk of holding or taking positions in
equities in the trading book is set out below. It applies to all instruments that exhibit
market behaviour similar to equities. The instruments covered include equity shares
(voting and non-voting), convertible securities that behave like equities ( e.g.: units of
unit trusts) and commitments to buy or sell equity securities ( e.g.: warrants, right issues
and bonus issues).
6.7.4.2  Specific and General Market Risk
6.7.4.2.1  Specific Equity Risk
 Specific risk is defined as the bank’s gross equity positions ( i.e., the sum of
all long equity positions and of all short equity positions). The capital charge
for specific risk for equities on the Milanka Price Index will be 5 per cent,
while all other equities will have a specific risk charge of 10 per cent.
6.7.4.2.2  General Equity Risk
 General market risk is defined as the overall net position in an equity market
(i.e., the difference between the sum of the longs and the sum of the shorts).
The general market risk charge will be 10 per cent .
6.7.5   Measur ement of the Capital Charge for Foreign Exchange and Gold Open Positions
6.7.5.1  T his section sets out the minimum capital requirement to cover the risk of holding
or taking positions in foreign currencies, including gold. Gold is treated as a foreign
exchange position rather than a commodity because its volatility is more in line with
foreign currencies, and banks manage it in a similar manner.
6.7.5.2  The  Off-balance sheet position, including forward contracts, will be included in
computation of the capital charge for foreign exchange risks.
6.7.5.3  Computing the capital requirement for foreign exchange risk consists of two processes.
6.7.5.3.1  Measuring the Exposur e in a Single Currency Position


6.7.5.3.1  Measuring the Exposur e in a Single Currency Position
 The bank’s net open position in each currency should be calculated by
summing the net position of all on balance sheet and off-balance sheet position,
including forward contracts denominated in that particular currency.
6.7.5.3.2  Measuring the Risks Inherent in a Bank’s Mix of Long and Short
Positions in Different Currencies
 Banks are required to adopt the shorthand method of computation. Under the
shorthand method, the nominal amount of the net position in each foreign
currency and in gold is converted at spot rates into the reporting currency
(i.e., LKR). The overall net open position is measured by aggregating:
 (i) the sum of the net short positions or the sum of the net long positions,
whichever is the greater, plus
 (ii) the net position (short or long) in gold, regardless of sign.
6.7.5.4  The capital char ge will be 10 per cent of the overall net open position of foreign currency
and gold.
Table 19
Example of the Shorthand Measure of Foreign Exchange Risk
YEN EURO GB INR US$ GOLD
+50 +100 +150 -20 -180 -35
+300 -200 -35


Directions, Determinations, and Circulars issued to Licensed Specialised Banks  47
In the above example, the capital charge would be 10 per cent of the higher
of either the net long currency positions or the net short currency positions
(i.e., 300) and of the net position in gold (35) = 335 x 10% = 33.5.
6.7.6  Aggr egation of the Capital Charge for Market Risks
 The capital charges for specific risk and general market risk are to be computed separately before
aggregation.
6.7.7  Capital Charge for  Interest Rate Derivatives
 The capital charge for interest rate derivatives will be excluded from the capital charge for market
risks at present and will be introduced shortly.
6.7.8  Specific Instruction for  completion of Part IV return
 (Computation of Risk-weighted amount for  Market Risk)
6.7.8.1  T otal Capital Charge for Market Risk
 (WBRC 1 1.4.1.0.0.0)
 The total amount of capital char ge for interest rate risk (6.7.8.1.1), capital charge
for equity risk (6.7.8.1.2) and capital charge for foreign exchange risk (6.7.8.1.3).
The amount is automatically shown on web-based return.
 (WBRC 1 1.4.1.1.0.0 + 11.4.1.2.0.0 + 11.4.1.3.0.0)
6.7.8.1.1  Capital Charge for  Interest Rate Risk
 (WBRC 1 1.4.1.1.0.0)
 The total amount of capital char ge for general interest rate risk and capital
charge for specific interest rate risk. The amount is automatically shown on
web-based return.
 (WBRC 1 1.4.1.1.1.0 + 11.4.1.1.2.0)
 (i) General Interest Rate Risk
  (WBRC 1 1.4.1.1.1.0)
  Capital char ge for general interest rate risk should be calculated in line
with the specific instruction given in the paragraph 6.7.3.3.2
 (ii) Specific Interest Rate Risk
  (WBRC 1 1.4.1.1.2.0)
  Capital char ge for specific interest rate risk should be calculated in line
with the specific instruction given in the paragraph 6.7.3.3.1
6.7.8.1.2  Capital Charge for  Equity Risk
 (WBRC 1 1.4.1.2.0.0)
 The total amount of capital char ge for general equity risk and capital charge


The total amount of capital char ge for general equity risk and capital charge
for specific equity risk. The amount is automatically shown on web-based
return.
 (WBRC 1 1.4.1.2.1.0 + 11.4.1.2.2.0)
 (i) General  Equity Risk
  (WBRC 1 1.4.1.2.1.0)
  Capital charge for general equity risk should be calculated in line with the
specific instruction given in the paragraph 6.7.4.2.2.
 (ii) Specific Equity Risk
  (WBRC 1 1.4.1.2.2.0)
  Capital charge for specific equity risk should be calculated in line with the
specific instruction given in the paragraph 6.7.4.2.1.


48 Directions, Determinations, and Circulars issued to Licensed Specialised Banks
6.7.8.1.3  Capital Charge for  Foreign Exchange & Gold
 (WBRC 1 1.4.1.3.0.0)
 Capital charge for Foreign exchange & gold should be calculated in line with
the specific instruction given in the paragraph 6.7.5.
6.7.8.2  T otal Risk-weighted Amount for Market Risk
 (WBRC 1 1.4.2.0.0.0)
 The total amount of risk-weighted amount for market risk should be ten times the capital
charge for market risk (6.7.8.1*10). The amount is automatically shown on web-based
return.
 (WBRC 1 1.4.1.0.0.0*10)
6.8 Part V – Computation of Risk-weighted Amount for Operational Risk.
6.8.1  Capital Charge for  Operational Risk
6.8.1.1  Definition of Operational Risk:  Operational risk is defined as the risk of loss resulting
from inadequate or failed internal processes, people and systems or from external events.
This definition includes legal risk, but excludes strategic and reputational risk. Legal risk
includes, but is not limited to, exposure to fines, penalties, or punitive damages resulting
from supervisory actions, as well as private settlements.
6.8.1.2  The Basic Indicator  Approach (BIA): To begin with, banks shall compute the capital
requirements for operational risk under the BIA. Under the BIA, banks must hold
capital for operational risk equal to the average over the previous three years of a fixed
percentage (denoted α) of positive annual gross income. Figures for any year in which
annual gross income is negative or zero should be excluded from both the numerator and
denominator when calculating the average.
6.8.1.3  The char ge may be expressed as follows:
KBIA = [ ∑ (GI 1…n x α.) ] / n
 Where;
KBIA  = the capital char ge under the Basic Indicator Approach
GI  = annual gross income, where positive, over the previous three audited financial
years
n  = number of the previous three financial years for which gross income is positive
α  = 15%, which is set by the BCBS.


α  = 15%, which is set by the BCBS.
6.8.1.4  Gross income is defined as “net interest income” plus “net non-interest income”. It is
intended that this measure should:
6.8.1.4.1  be gross of any provisions ( e.g.: for unpaid interest),
6.8.1.4.2  be gross of operating expenses, including fees paid to outsourcing service
providers, in contrast to fees paid for services that are outsourced, fees
received by banks that provide outsourcing services shall be included in the
definition of gross income,
6.8.1.4.3  exclude realized profits/losses from the sale of securities in the banking book,
and
6.8.1.4.4  exclude extraordinary or irregular items.
6.8.1.5  Banks are advised to compute the capital char ge for operational risk under the BIA as
follows:
6.8.1.5.1  A verage of [  Gross Income x α  ] for each of the last three financial years,
excluding years of negative or zero gross income


Directions, Determinations, and Circulars issued to Licensed Specialised Banks  49
6.8.1.5.2  Gross income = Net interest income + non-interest income – items (6.8.1.4.3)
and (6.8.1.4.4) of above.
6.8.1.5.3  α = 15%
6.8.2  Specific Instruction for  completion of Part V
 (Computation of Risk-weighted amount for  Operational Risk)
6.8.2.1  Gr oss Income
 (WBRC 1 1.5.1.0.0.0)
 The total gross income should be total net income (6.8.2.1.1) less total exclude items as
specified in the paragraph 6.8.1.4.3 and 6.8.1.4.4. The amount is automatically shown on
web-based return.
 (WBRC 1 1.5.1.1.0.0 - 11.5.1.2.0.0)
6.8.2.1.1  Net Income
 (WBRC 1 1.5.1.1.0.0)
 The total net income should be sum of total net interest income and total non-
interest income. The amount is automatically shown on web-based return.
 (WBRC 1 1.5.1.1.1.0 + 11.5.1.1.2.0)
 (i) Net Inter est Income
  (WBRC 1 1.5.1.1.1.0)
  The total net interest income should be the total interest income less
total non-interest expenses as reported in the annual audited profit and
loss statement.
 (ii) Non-Inter est Income
  (WBRC 1 1.5.1.1.2.0)
  The total non-interest income should be the total income other than the
interest income.
6.8.2.1.2  Less Amount
 (WBRC 1 1.5.1.2.0.0)
 The total aggregate amount of following items, as specified in the paragraph
6.8.1.4.3 and 6.8.1.4.4, which banks are required to deduct from total net
income.
6.8.2.2  T otal Capital Charge for Operational Risk
 (WBRC 1 1.5.2.0.0.0)
 The total capital char ge for operational risk should be 15 per cent of gross income
(6.8.2.1.) above. The amount is automatically shown on web-based return.
 (WBRC 1 1.5.1.0.0.0*15%)
6.8.2.3  T otal Risk-weighted Amount for Operational Risk
 (WBRC 1 1.5.3.0.0.0)
 The total amount of risk-weighted amount for operational risk should be ten times the
capital charge for operational risk (6.8.2.2*10). The amount is automatically shown on
web-based return.
 (WBRC 1 1.5.2.0.0.0*10)


50 Directions, Determinations, and Circulars issued to Licensed Specialised Banks
Schedule II
CAPITAL ADEQUACY RATIO OF
LICENSED COMMERCIAL / SPECIALISED BANKS
BANK ONLY (SOLO Basis) / CONSOLIDATED RETURN


Directions, Determinations, and Circulars issued to Licensed Specialised Banks  51
Part I – Computation of Capital Adequacy Ratio (Rs. ’000)
Web-based
Return CodeItem Amount
11.1.1.0.0.0 Eligible Core Capital (Eligible Tier I) = 11.2.1.1.0.0 of Part II ( a)
11.1.2.0.0.0 Capital Base = 11.2.1.5.0.0 of Part II (a )
11.1.3.0.0.0 Total Risk-weighted Amount
11.1.3.1.0.0 Risk-Weighted Amount for Credit Risk = 11.3.1.0.0.0 of Part III ( a)
11.1.3.2.0.0 Risk-Weighted Amount for Market Risk = 11.4.2.0.0.0 of Part IV
11.1.3.3.0.0 Risk-Weighted Amount for Operational Risk = 11.5.3.0.0.0 of Part V
11.1.4.0.0.0 Core Capital (Tier 1) Ratio, % = (11.1.1.0.0.0/11.1.3.0.0.0)*100
11.1.5.0.0.0 Total Capital Ratio, % = (11.1.2.0.0.0/11.1.3.0.0.0)*100
Part II (a ) – Computation of Total Capital Base (Rs. ’000)
Web-based
Return CodeItem Amount
11.2.1.1.0.0 Eligible Core Capital (Eligible Tier I)
11.2.1.1.1.0 Core Capital (Tier 1)
11.2.1.1.1.1 Paid-up Ordinary Shares/ Assigned Capital
11.2.1.1.1.2 Non-cumulative, Non-redeemable Preference Shares
11.2.1.1.1.3 Share Premium
11.2.1.1.1.4 Statutory Reserve Fund
11.2.1.1.1.5 Published Retained Profits/(Accumulated Losses) (+/-)
11.2.1.1.1.6 General and Other Reserves
11.2.1.1.1.7 Gain/(Loss) After Tax arising from the Sale of Fixed and Long-term
Investments
11.2.1.1.1.8 Unpublished Current Year’s Profit/(Loss) (+/-)
11.2.1.1.1.9 Minority Interests (consistent with the above capital constituents)
11.2.1.1.1.10 Perpetual Debt Capital Instruments
11.2.1.1.2.0 Deductions/ Adjustments-Tier 1
11.2.1.1.2.1 Goodwill
11.2.1.1.2.2 Net Deferred Tax
11.2.1.1.2.3 Other Intangible Assets
11.2.1.1.2.4 Advances granted to employees of the bank for the purchase of
shares of the bank under a share ownership plan.
11.2.1.1.2.5 Amount due from head office & branches outside Sri Lanka in Sri
Lanka Rupees
(applicable only to branches of foreign banks)
11.2.1.1.2.6 Amount due to head office & branches outside Sri Lanka in Sri Lanka
Rupees (-)


11.2.1.1.2.6 Amount due to head office & branches outside Sri Lanka in Sri Lanka
Rupees (-)
(applicable only to branches of foreign banks)


52 Directions, Determinations, and Circulars issued to Licensed Specialised Banks
Web-based
Return CodeItem Amount
11.2.1.1.2.7 Amount due from head office & branches outside Sri Lanka in
Foreign Currency (net)
(applicable only to branches of foreign banks)
11.2.1.1.2.8 50% of Investments in Unconsolidated Banking and Financial
Subsidiary Companies
11.2.1.1.2.9 50% of Investments in the Capital of Other Banks and Financial
Institutions
11.2.1.2.1.0 Supplementary Capital (Tier II)
11.2.1.2.1.1 Revaluation Reserves (approved by CBSL)
11.2.1.2.1.2 General Provisions
11.2.1.2.1.3 Hybrid Capital Instruments (Debt/Equity)
11.2.1.2.1.4 Minority Interests arising from Preference Shares
11.2.1.2.1.5 Approved Subordinated Term Debt
0.0.0.0.0.0 Actual Amount of Approved Subordinated Term Debts
11.2.1.2.2.0 Deductions -Tier 1I
11.2.1.2.2.1 50% of Investments in Unconsolidated Banking and Financial
Subsidiary Companies
11.2.1.2.2.2 50% of Investments in the Capital of Other Banks and Financial
Institutions
11.2.1.2.0.0 Total Supplementary Capital
(Tier II) = (Item 11.2.1.2.1.0 - 11.2.1.2.2.0)
11.2.1.3.0.0 Eligible Supplementary Capital (Eligible Tier II)
11.2.1.4.0.0 Short Term Subordinated Debt (Tier III Capital)
11.2.1.4.1.0 Approved Short Term Subordinated Debt
11.2.1.4.2.0 Eligible Tier III Capital-Utilised = (item 11.2.2.6.1.0)
11.2.1.5.0.0 Capital Base
Part I1 (b ) – Computation of Eligible Tier III Capital for Market Risk (Rs. ’000)
Web-based
Return CodeItem Amount
11.2.2.1.0.0 Total Risk Weighted Assets (RWA)
11.2.2.1.1.0 Total Risk Weighted Assets for Credit and Operational Risks
11.2.2.1.2.0 Total Risk Weighted Assets for Market Risk
11.2.2.2.0.0 Minimum Capital Charge
11.2.2.2.1.0 Capital Charge for Credit and Operational Risk
11.2.2.2.2.0 Capital Charge for Market Risk
11.2.2.3.0.0 Total Capital Available to Meet the Capital Charge for Credit
and Operational Risks
11.2.2.4.0.0 Total Capital Base Available to meet Market Risk


and Operational Risks
11.2.2.4.0.0 Total Capital Base Available to meet Market Risk
11.2.2.5.0.0 Total Available Tier III Capital
11.2.2.5.1.0 Approved Short-term Subordinated Debt


Directions, Determinations, and Circulars issued to Licensed Specialised Banks  53
Web-based
Return CodeItem Amount
11.2.2.5.2.0 Minimum of 28.5% of Capital Charge for Market Risk to be met
by Tier 1 Capital that is not Required for Credit Risk
11.2.2.5.2.1 (a) Limit
11.2.2.5.2.2 (b) Amount Utilised
11.2.2.5.3.0 Maximum of 250% of Tier 1 Capital that is not Required for
Credit and Operational Risks
11.2.2.5.3.1 (a) Limit
11.2.2.5.3.2 (b) Amount Utilised
11.2.2.6.0.0 Eligible Tier III Capital
11.2.2.6.1.0 Eligible Tier III Capital Utilised
11.2.2.6.2.0 Eligible but Unutilized Tier III Capital
Part III (a ) – Computation of Risk-weighted Amount for Credit Risk
 (Rs. ’000)
Web-based
Return
CodeItem AmountCredit
Equivalent
of
Off-balance
Sheet ItemsTotalRisk
Weight
%Risk
Weighted
Assets
Amount
11.3.1.0.0.0 Total Risk-weighted Amount
for Credit Risk
11.3.1.1.0.0 Claims on Government of Sri
Lanka and Central Bank of Sri
Lanka
11.3.1.1.1.0 Government of Sri Lanka
11.3.1.1.2.0 Central Bank of Sri Lanka
11.3.1.2.0.0 Claims on Foreign Sovereigns
and their Central Banks
11.3.1.2.1.0 AAA to AA- 0
11.3.1.2.2.0 A+ to A- 20
11.3.1.2.3.0 BBB+ to BBB- 50
11.3.1.2.4.0 BB+ to B- 100
11.3.1.2.5.0 Below B- 150
11.3.1.2.6.0 Unrated 100
11.3.1.3.0.0 Claims on Public Sector
Entities PSEs)
11.3.1.3.1.0 AAA to AA- 20
11.3.1.3.2.0 A+ to A- 50
11.3.1.3.3.0 BBB+ to BB- 100
11.3.1.3.4.0 Below BB- 150
11.3.1.3.5.0 Unrated 100


54 Directions, Determinations, and Circulars issued to Licensed Specialised Banks
Web-based
Return
CodeItem AmountCredit
Equivalent
of
Off-balance
Sheet ItemsTotalRisk
Weight
%Risk
Weighted
Assets
Amount
11.3.1.4.0.0 Claims on Official Entities
and Multilateral Development
Banks (MDBs)
11.3.1.4.1.0 BIS,IMF, ECB, EC and Eligible
MDBs0
11.3.1.4.2.0 AAA to AA- 20
11.3.1.4.3.0 A+ to BBB- 50
11.3.1.4.4.0 BB+ to B- 100
11.3.1.4.5.0 Below B- 150
11.3.1.4.6.0 Unrated 100
11.3.1.5.0.0 Claims on Banks
11.3.1.5.1.0 Rupee Exposures less than 3
months
11.3.1.5.1.1 AAA to BBB- 20
11.3.1.5.1.2 BB+ to B- 50
11.3.1.5.1.3 Below B- 150
11.3.1.5.1.4 Unrated 100
11.3.1.5.2.0 Foreign Currency Exposures
less than 3 months
11.3.1.5.2.1 AAA to A- 20
11.3.1.5.2.2 BBB+ to BBB- 50
11.3.1.5.2.3 BB+ to B- 100
11.3.1.5.2.4 Below B- 150
11.3.1.5.2.5 Unrated 100
11.3.1.5.3.0 Rupee and Foreign Currency
Exposures more than 3 months
11.3.1.5.3.1 AAA to AA- 20
11.3.1.5.3.2 A+ to BBB- 50
11.3.1.5.3.3 BB+ to B- 100
11.3.1.5.3.4 Below B- 150
11.3.1.5.3.5 Unrated 100
11.3.1.6.0.0 Claims on Financial
Institutions
11.3.1.6.1.0 Claims on Primary Dealers/
Finance Companies/Specialised
Leasing Companies
11.3.1.6.1.1 AAA to AA- 20
11.3.1.6.1.2 A+ to BBB- 50
11.3.1.6.1.3 BB+ to B- 100


Directions, Determinations, and Circulars issued to Licensed Specialised Banks  55
Web-based
Return
CodeItem AmountCredit
Equivalent
of
Off-balance
Sheet ItemsTotalRisk
Weight
%Risk
Weighted
Assets
Amount
11.3.1.6.1.4 Below B- 150
11.3.1.6.1.5 Unrated 100
11.3.1.6.2.0 Claims on Other Financial
Institutions
11.3.1.6.2.1 AAA to AA- 20
11.3.1.6.2.2 A+ to A- 50
11.3.1.6.2.3 BBB+ to BB- 100
11.3.1.6.2.4 Below BB- 150
11.3.1.6.2.5 Unrated 100
11.3.1.7.0.0 Claims on Corporates
11.3.1.7.1.0 AAA to AA- 20
11.3.1.7.2.0 A+ to A- 50
11.3.1.7.3.0 BBB+ to BB- 100
11.3.1.7.4.0 Below BB- 150
11.3.1.7.5.0 Unrated 100
11.3.1.8.0.0 Retail Claims
11.3.1.8.1.0 Retail claims that qualify  for
regulatory capital purposes75
11.3.1.8.2.0 Retail claims that not qualify  for
regulatory capital purposes100
11.3.1.9.0.0 Claims Secured by Residential
Property
11.3.1.9.1.0 Claims that qualify for
regulatory capital purposes50
11.3.1.9.2.0 Claims that not qualify  for
regulatory capital purposes100
11.3.1.10.0.0 Claims Secured by Commercial
Real Estate100
11.3.1.11.0.0 Non-Performing Assets (NPAs)
11.3.1.11.1.0 Specific provisions are equal or
more than 20%100
11.3.1.11.2.0 Specific provisions are less than
20%150
11.3.1.12.0.0 Non-Performing Assets
Secured by Residential
Property
11.3.1.12.1.0 Specific provisions are equal or
more than 20%50
11.3.1.12.2.0 Specific provisions are less than
20%100


56 Directions, Determinations, and Circulars issued to Licensed Specialised Banks
Web-based
Return
CodeItem AmountCredit
Equivalent
of
Off-balance
Sheet ItemsTotalRisk
Weight
%Risk
Weighted
Assets
Amount
11.3.1.13.0.0 Higher-Risk Categories 150
11.3.1.14.0.0 Cash Items and Other Assets
11.3.1.14.1.0 Cash Items
11.3.1.14.1.1 Notes and Coins
11.3.1.14.1.2 Gold Bullion held in own vault
11.3.1.14.1.3 Cash Items in the Process of
Collection20
11.3.1.14.2.0 Other Assets
11.3.1.14.2.1 Fixed Assets 100
11.3.1.14.2.2 Other Assets/Exposures 100
Part III (b ) – Credit equivalent of Off-Balance Sheet Items
(Rs.’000)
Web-based
Return CodeDescriptionPrincipal
amount of
Off-Balance
Sheet ItemsCredit
Conversion
Factor
(%)Credit
equivalent
of
Off-Balance
Sheet Items
11.3.2.0.0.0 Off-balance Sheet Items
11.3.2.1.0.0 Direct Credit Substitutes
11.3.2.1.1.0 General Guarantees of Indebtedness 100
11.3.2.1.2.0 Stand-by LCs serving as Financial
Guarantees100
11.3.2.1.3.0 Bank Acceptances 100
11.3.2.1.4.0 Others (please specify) 100
11.3.2.2.0.0 Transaction-related Contingencies
11.3.2.2.1.0 Performance Bonds, Bid Bonds &
Warranties50
11.3.2.2.2.0 Stand-by LCs related to particular
Transactions50
11.3.2.2.3.0 Others (please specify) 50
11.3.2.3.0.0 Short-Term Self-Liquidating Trade-
Related Contingencies
11.3.2.3.1.0 Shipping Guarantees 20
11.3.2.3.2.0 Documentary Letters of Credit 20
11.3.2.3.3.0 Trade related Acceptances 20
11.3.2.3.4.0 Others (please specify) 20


Directions, Determinations, and Circulars issued to Licensed Specialised Banks  57
Web-based
Return CodeDescriptionPrincipal
amount of
Off-Balance
Sheet ItemsCredit
Conversion
Factor
(%)Credit
equivalent
of
Off-Balance
Sheet Items
11.3.2.4.0.0 Sale and Repurchase Agreements and
Assets Sale with Recourse where the
Credit Risk remains with the Bank
11.3.2.4.1.0 Sale and Repurchase Agreements 100
11.3.2.4.2.0 Housing Loans sold with Recourse 100
11.3.2.4.3.0 Other Assets sold with Recourse 100
11.3.2.4.4.0 Forward Assets Purchase 100
11.3.2.4.5.0 Partly paid Shares/Securities 100
11.3.2.4.6.0 Others (please specify) 100
11.3.2.5.0.0 Obligations under an On-going
Underwriting Agreement
11.3.2.5.1.0 Underwriting of Shares/Securities Issue 50
11.3.2.5.2.0 Note Issuance Facilities and Revolving
Underwriting Facilities50
11.3.2.5.3.0 Others (please specify) 50
11.3.2.6.0.0 Commitments with an Original
Maturity of up to one year or which
can be unconditionally cancelled at
any time
11.3.2.6.1.0 Formal Stand-by Facilities and Credit
Lines0
11.3.2.6.2.0 Undrawn Term Loans 0
11.3.2.6.3.0 Undrawn Overdraft Facilities/Unused
Credit Card Lines0
11.3.2.6.4.0 Others (please specify) 0
11.3.2.7.0.0 Other Commitments with an Original
Maturity up to 1 year
11.3.2.7.1.0 Formal Stand-by Facilities and Credit
Lines20
11.3.2.7.2.0 Undrawn Term Loans 20
11.3.2.7.3.0 Others (please specify) 20
11.3.2.8.0.0 Other Commitments with an Original
Maturity of over one year
11.3.2.8.1.0 Formal Stand-by Facilities and Credit
Lines50
11.3.2.8.2.0 Undrawn Term Loans 50
11.3.2.8.3.0 Others (please specify) 50


58 Directions, Determinations, and Circulars issued to Licensed Specialised Banks
Web-based
Return CodeDescriptionPrincipal
amount of
Off-Balance
Sheet ItemsCredit
Conversion
Factor
(%)Credit
equivalent
of
Off-Balance
Sheet Items
11.3.2.9.0.0 Exchange Rate Contracts
11.3.2.9.1.0 Original Maturity-less than one year 2
11.3.2.9.2.0 Original Maturity-more than one year
and less than two years5
11.3.2.9.3.0 Original Maturity-more than two years
(For each additional year)3
(for each
year)
11.3.2.10.0.0 Interest Rate Contracts
11.3.2.10.1.0 Original Maturity-less than one year 0.5
11.3.2.10.2.0 Original Maturity-more than one year
and less than two years1
11.3.2.10.3.0 Original Maturity-more than two years
(For each additional year)1
(for each
year)

Part III (c ) – Exposures Recognised under Credit Risk Mitigation (CRM)
(Rs. ’000)
Web-based
Return CodeCRM techniquesPrincipal
Amount
11.3.3.0.0.0 Total CRM Exposure
11.3.3.1.0.0 Collateralised Transactions
11.3.3.1.1.0 Retail Exposure
11.3.3.1.1.1 Cash
11.3.3.1.1.2 Gold
11.3.3.1.1.3 Government Securities
11.3.3.1.1.4 Provident Fund Balances
11.3.3.1.1.5 Debt Securities Rated by a recognised ECAIs
11.3.3.1.1.6 Debt Securities not Rated by a recognised ECAIs
11.3.3.1.1.7 Equities that are included in a Main Index.
11.3.3.1.2.0 Other Exposures
11.3.3.1.2.1 Cash
11.3.3.1.2.2 Gold
11.3.3.1.2.4 Provident Fund Balances
11.3.3.1.2.3 Government Securities
11.3.3.1.2.5 Debt Securities Rated by a recognised ECAIs
11.3.3.1.2.6 Debt Securities not Rated by a recognised ECAIs
11.3.3.1.2.7 Equities that are included in a Main Index.
11.3.3.2.0.0 Other CRM Techniques
11.3.3.2.1.0 On-balance Sheet Netting
11.3.3.2.2.0 Guarantees


Directions, Determinations, and Circulars issued to Licensed Specialised Banks  59
Part IV – Computation of Risk-weighted Amount for Market Risk
(Rs. ’000)
Web-based
Return CodeItemCapital Charge
Amount
11.4.1.0.0.0 Total Capital Charge for Market Risk
= (11.4.1.1.0.0+11.4.1.2.0.0+11.4.1.3.0.0)
11.4.1.1.0.0 Capital Charge for Interest Rate
= (11.4.1.1.1.0+11.4.1.1.2.0)
11.4.1.1.1.0 General Interest Rate Risk
11.4.1.1.1.1 i) Net Long or Short Position
11.4.1.1.1.2 ii) Horizontal Disallowance
11.4.1.1.1.3 iii) Vertical Disallowance
11.4.1.1.1.4 iv) Options
11.4.1.1.2.0 Specific Interest Rate Risk
11.4.1.2.0.0 Capital Charge for Equity = (11.4.1.2.1.0+11.4.1.2.2.0)
11.4.1.2.1.0 General Equity Risk
11.4.1.2.2.0 Specific Equity Risk
11.4.1.3.0.0 Capital Charge for Foreign Exchange & Gold
11.4.2.0.0.0 Total Risk-weighted Amount for Market Risk
= (11.4.1.0.0.0*10)
Part V – Computation of Risk-weighted Amount for Operational Risk
(Rs. ’000)
Web-based
Return CodeItemFirst
YearSecond
YearThird
YearTotal Average
11.5.1.0.0.0 Gross Income
11.5.1.1.0.0 Net Income
11.5.1.1.1.0 Net Interest Income (Interest
Income-Interest Expenses)
11.5.1.1.2.0 Non-interest Income
11.5.1.2.0.0 Less
11.5.1.2.1.0 Realised Profits from the Sale of
Securities in the Banking Book
11.5.1.2.2.0 Extraordinary / Irregular Items of
Income
11.5.2.0.0.0 Total Capital Charge for
Operational Risk
= (11.5.1.0.0.0*15%)
11.5.3.0.0.0 Total Risk-weighted Amount for
Operational Risk
= (11.5.2.0.0.0*10)


60 Directions, Determinations, and Circulars issued to Licensed Specialised Banks
Annex I
IMPLEMENTATION OF IT INFRASTRUCTURE FOR BASEL II
1. Implementation of IT  Architecture and Design Principles for Basel II
Important requirements for this architecture are as follows;
• C reate a robust, scalable & network friendly Basel II technology framework, which can
support a regional user and is extendable to new regulatory compliance requirements as the
Bank increases its presence in the emerging markets.
• Rationalise the technologies by choosing common platforms for common requirement across
all Pillars and common business domain across all Pillars. This will reduce total cost of
ownership, maintenance overheads and will facilitate change management for the bank.
• Adopt a robust and centralised data collection and consolidation approach for Basel II through
the Banking Data Warehouse (BDW) for risk analytics and Consolidated reporting
• Reduce manual data capture methods for Basel II.
• Design for Basel II applications should cater for high availabi lity, proper exception handling
and proper backup/recovery to ensure that potential risk due to data loss during unforeseen
circumstances is negligible.
• All new core banking applications and credit related applications in all geographical regions
must be Basel II compliant.
• All Basel II applications must adhere to the bank’s policies for infrastructure security, data
security, application controls and user administration.
• All Basel II applications should demonstrate disaster recovery as a capability.
2. Requir ements for a Regulatory Capital IT Solution
The following eight elements are the system level requirements that a financial services
institution must meet to comply with the Basel II Accord.
2.1 Storage of Curr ent and Historical Data in a Data Warehouse
Basel II calls for financial institutions to store a substantial quantity of data. To produce


Basel II calls for financial institutions to store a substantial quantity of data. To produce
a measure of Risk Weighted Assets, the Bank for International Settlement (BIS) requires
financial institutions to store a comprehensive database of operational loss incidents,
financial instruments, credit losses, and general ledger data. For financial institutions that
seek to calculate Pillar I capital using the Advanced IRB approach for retail or wholesale
assets, seven years of default data are required to validate internal ratings models. Beyond
historical data storage requirements, a Basel II compliant IT solution must also provide
the ability to store and process multiple versions of data. For example, in the area of stress
testing, financial institutions are required to test the assumptions of their models in a variety
of economic scenarios. Given these requirements, scalable and efficient storage of current,
historical, and alternative scenario data is critical.
2.2 Auditable and Flexible Risk Weighted Asset Calculations
The Basel II Capital Accord defines a large number of rules for calculating Risk Weighted
Assets and minimum required capital for credit, market and operational risks. However,
beyond simply performing calculations, the BIS also requires that financial institutions have
the ability to easily adjust these calculations, and the categorisations on which they depend.
The Accord also implicitly requires that a financial services institution be able to switch
between the various Pillar I methodologies. Therefore, a regulatory capital IT solution


Directions, Determinations, and Circulars issued to Licensed Specialised Banks  61
should not only provide all of the required calculations within the Accord, but should also
allow auditors, regulators, and internal users to audit, review and revise these calculations
as necessary. There are also certain areas where the Accord gives financial institutions the
flexibility to optimise capital calculations such as in the case of collateral application.
2.3 Contr ol Management with automatic workflows
The Basel II framework requires financial institutions to demonstrate that they have the
appropriate procedures and controls in place to manage their risks. Therefore, a regulatory
capital IT system should allow financial institutions to map controls against their risks.
In such a framework, financial institutions can define automatic workflows where the system
prompts employees to act based on certain defined key performance indicators (KPIs) or
user-defined business events. Finally, the system should also allow financial institutions
to audit and monitor their controls and procedures in order to periodically assess their risk
management practices based on actual loss experience.
2.4 Sophisticated Analytical Tools
Financial institutions can implement sophisticated models to assess their risk position and
optimise usage of capital. The BIS allows qualifying financial institutions to implement
internal models for Probability of Default (PD), Loss Given Default (LGD), and Exposure at
Default (EAD). Therefore, a regulatory capital IT solution must allow a financial institution
to implement and test any model that can properly assess its risk position. These external
applications would also have the ability to write information back to a central data source.
2.5 Flexible User  Driven methods
The Basel II Accord defines a vast range of calculations and options. Examples of these


The Basel II Accord defines a vast range of calculations and options. Examples of these
options include whether to use the Simple or Comprehensive approach for credit risk
mitigation, to use supervisory or own-estimate haircuts, and to determine the risk weighted
assets based on a top-down approach. Given the range of possibilities, users must have
the flexibility to easily change the methods they use to calculate risk-weighted assets
and assess the potential impact of those changes. Users should also have the flexibility to
specify which specific calculation components are processed in a given job submission.
For example, the system should not force the user to reprocess every single statistic if
all they seek to do is recalculate a subset of the organisation’s assets. Additionally, the
user should have the option to generate detailed auditing output, either for a sampling of
accounts or an individual transaction at their discretion.
2.6 Coordinated Pr ocess Flow
The Basel II calculations requires data that would generally originate from different
processing systems, including those used to support front office, back office and risk
management operations. Further, the Accord requires synchronisation of this data to
perform calculations on a consistent and integrated basis. Once calculations are completed,
the system may need to further process the output data through a variety of third party
applications for further analysis or reporting. Given these complex data workflow
requirements, a regulatory capital solution needs to consolidate each of these process flow
issues without any error.
2.7 T imely reporting that meets Internal and External Requirements
Systems and data are irrelevant if they do not provide information in a timely manner.
Under the Basel II regime, financial institutions need to meet highly specific and demanding
external and regulatory reporting requirements. Simultaneously, internal management


external and regulatory reporting requirements. Simultaneously, internal management
requires a continuous stream of information to better understand their organization’s


62 Directions, Determinations, and Circulars issued to Licensed Specialised Banks
risk profile. Therefore, it is essential that a regulatory capital solution provide a sound
management reporting platform. A Basel II compliant IT solution must be able to regularly
and accurately produce the necessary internal and external reports for sound risk and
profitability management.
2.8 Low Cost and Low Risk
Financial services management and information systems professionals do not have the time
or the budget to deal with high priced or unreliable solutions. For this reason, any regulatory
capital solution must maintain a low total cost of ownership and be highly reliable.
The major components of the regulatory capital IT solution should be covered through
a single data source so that constant reconciliation of data is avoided. Just as important,
the system needs to eliminate the constant administrative management inherent to many
enterprise systems. It should not have to rely on vigilant system administrators to coordinate
the functioning of different applications.
3. Data Integration and the Data Warehouse
There is a need to align the data structures that drive risk and financial data. These are:
1. Transactional data that covers all types of transaction and links the financial results of
each transaction with the risk and financial objectives of the financial institution.
2. Asset data  that covers all types of assets that might be linked to the transaction, the
valuation of these assets and the correlation of asset behaviour.
3. Customer data for all counter-parties, which includes the credit risk of the counterparty
and makes provisions when new information or circumstances changes that risk. Detailed
data on customers are required to support product selection and pricing in addition to other
relationship management decisions.
The above risk and financial data could be broadly categorised as follows:


The above risk and financial data could be broadly categorised as follows:
Instrument/Account Data –  These data cover basic information about every financial
instrument held by the financial institution, i.e. Data about financial instruments such as
exposure (provision/allowances, outstanding balances, credit lines, etc.), maturity, asset,
product and industry classifications, interest rates, and so on.
Customer/Counterparty Data –  This refers to the relevant data for different parties that a
financial institution may deal with in a financial transaction. In addition, these data cover
information such as industry classification and customer financial information that may be
used in deriving PD estimates such as debt to equity ratios, current assets, net sales, retained
earnings, revenues, profits, cost of goods, share price, and bond price. Financial institutions
may use these data with regulatory capital data to perform customer-based profitability analysis.
Ledger Data – These data cover transaction and account balance data stored in a ledger. Ledger
data are used to do business unit and product based profitability analysis. Users may analyse
and report on capital for market, credit, and operational risk.
Risk Mitigation Data –  These data cover information about collateral, insurance, netting
agreements, credit derivatives, and guarantees. Among other attributes, these data include
the mitigant type, mitigation value, maturity of the instrument, and the specific instrument to
which the collateral maps. Insurance policy data information are relevant for the mitigation of
operational risks.
Incident Data – Analysis of credit and operational loss incidents depends upon having granular
incident data. This data covers the essential information about loss incidents such as loss
amount, business unit, loss description and risk category.


Directions, Determinations, and Circulars issued to Licensed Specialised Banks  63
Historical Data –  If financial institutions opt for the Advanced Internal Ratings based approach
for credit risk and the Advance Measurement approach for operational risk, they must store
a substantial volume of historical data. These data will be necessary to test historical default
experiences against the forecasted values generated by predictive models. These data cover both
historical credit and operational loss data.
Limits and Loss Provision Data –  The Basel II requirement is that the financial institutions
should limit their exposures for lending based on industries, geography, and specific customers.
These data cover the exposure limits and the loan loss provisions.
Examples of some data fields:
Borrower Legal Name, Customer Basel segment, Borrower Credit Grade, Consolidated Group
Turnover, Facility Currency, Limit Amount, Committed Limit Indicator, Collateral Type/Sub
Type, Country of Incorporation, Guarantor Credit Grade, Facility Type External Credit Rating,
Collateral Currency, Collateral Location, Negative Pledge Indicator, Maturity Date etc.
A typical Banking Data Warehouse for a financial institution could be as follows:
4. Data Governance & Management
4.1 Background
To achieve Basel II certification, the data used in all pillars must be effectively
managed. This includes both data management and technology governance. IRBA data
self-assessment requires a process to be in place for vetting inputs into internal rating systems.
It should include an assessment of the accuracy, completeness and appropriateness of data.
Establishment of standards and conducting relevant tests for accuracy, completeness,
timeliness and reliability  of data are essential to assess on  an ongoing basis  the risks
arising from potential poor quality data and to ensure that appropriate risk mitigation
measures have been undertaken.
4.2 Data Quality Management (DQM) framework


measures have been undertaken.
4.2 Data Quality Management (DQM) framework
Data quality management is an ongoing process and it consists of the stakeholders,
DQM process and DQM tools.
4.2.1  The Stakeholders
Data owners, system owners, data consumers and data services are the main
stakeholders. Data owners are responsible for the process of updating data into the


64 Directions, Determinations, and Circulars issued to Licensed Specialised Banks
system. They will define the data quality measurements, monitor data quality metrics,
report data quality metrics to data services and resolve data quality issues. A data
consumer is any stakeholder, who extracts data from another system for processing or
information services. They will report data quality issues to DQ dashboard/DQ log,
provide input and take part in the resolution of DQ issues and escalate DQ issues to
data service in the event of non-resolution. The owner of the data management policy
is Data Services. It will administer data ownership, resolve data ownership issues,
administer DQ Dashboard and Issues Log, facilitate root cause analysis process and
train data quality management.
4.2.2  Data Quality Management (DQM) Pr ocess
The DQM process can be elaborated under 6 steps.
Step 1 - Identification of Critical Quality Elements (CQE)
E.g., CQE for Probability of Default (PD) Drivers; Detailed Drivers – Borrower PD,
Guarantor PD, PD validation; Field names – CRR, Ratings, Date of Ratings etc.
Step 2 – Definition of quality (CACTI)
1. Completeness – Are all the necessary data captured and present?
(E.g., Is this field mandatory?)
2. Accuracy – Do the data accurately represent reality or a verified source?
(E.g., Is there maker/checker in place?)
3. Consistency – Are the data elements consistently defined and understood?
(E.g., Is there a drop down list in the system?)
4. T imeliness – Are the data available within the required timeframe?
(E.g., What is the agreed turnaround time to complete data
capture/extraction?)
5. Integrity - Is the structure of the data and the relationship between fields
maintained consistently?
(E.g., Is there data verification on the field?)
Step 3 – Controls and checks
The business process that support data collection, updating and maintenance should


The business process that support data collection, updating and maintenance should
have the appropriate quality controls and checkpoints in place. This is to ensure
that data fit for the purpose is produced as close to the point of entry as possible,
and avoids or reduces the possibility of data errors and the need for data cleansing.
Examples of a control point include a maker checker process or mandatory fields in
the system. There are 3 defined stages to this step,
a) Document the data process flow
b) Review control and checks using the CACTI framework
c) Implement additional control checkpoints if required.
Step 4 – Data quality measurement
1. It will provide quantifiable evidence of an ef fective data management process.
2. It can be used as a toll to monitor and track the data quality level.
3. When combined with the data quality tar get, the measurement can be used as a
trigger to commence a review of the data management process.


Directions, Determinations, and Circulars issued to Licensed Specialised Banks  65
4. The standard frequency for a data quality measurement is monthly . However, this
can vary depending on the type of data or system.
    % Quality level =  No. of records meeting requirements              X   100
                  Total No. of records in universe or sample
5. The data quality tar get level should be set at a level, which is:
 – Realistic, given current knowledge of the data quality level;
 – Represents the next step that the data owner wants to achieve in improving data
quality given incremental improvement is achievable.
Step 5 – Monitoring
1. Monitoring is critical to ensure the sustainability of any data  quality management effort.
2. Monitoring can be achieved through periodic data quality measurement, manual or system
error reporting
3. The data quality tar get level can be used as a tool to monitor data quality.
Step 6 – Data cleansing, problem resolution and Escalation
Data owners – To ensure that data cleansing and error correction is performed in a consistent,
systematic and methodical manner, a documented error correction procedure is critical.
Data consumers – Data consumers may put in place a process for error correction.
Data quality escalation – Within each department, ideally, there should exist an escalation path
for dealing with data quality problems. These may include escalation for inaccurate or missing
information, such as to the Business Unit Officer or Business Support Unit.
Data Quality Management Process – Six broad Data Quality Management (DQM) Process steps to
guide Data Owners and Consumers to perform data quality management
Identify
Critical
Quality
ElementsDefine Data
Quality
RequirementsDocument
Data
Flow
Review
Controls
and checks
In place
Implement
Additional
Control
checkpointsMeasure
Data quality
level
Monitor
Data quality
level
Identifies Critical
Quality elements
& provides input for
measurement
definitionMonitors data


Identifies Critical
Quality elements
& provides input for
measurement
definitionMonitors data
Quality as Data
Owner of
Downstream
applicationCleansing ,
Error
Resolution
Escalates data
Quality issues
& provide
inputs
on resolution1. Identification 2. Measurement
Definition3. Controls
& Checks4. Measure
5. Monitoring6. Escalation ,
Cleansing &
Resolution
Data Owner
&
System
Owner
Data
ComsumerData
Consumer


66 Directions, Determinations, and Circulars issued to Licensed Specialised Banks
5. T echnology Governance Framework
The following are the key requirements to consider from the Basel II Technology framework:
1. Robustness – Robustness is the resilience of the system, especially when under stress or
when confronted with invalid inputs. It is the ability of the software system to maintain
function even with changes in the internal structure or external environment.
2. Scalability – Scalability indicates the capability of a system to increase total throughput
under increased load when resources (typically hardware) are added. A scalable system is
one that can easily be altered to accommodate changes in the number of users, resources and
computing entities.
3. Security & Controls – The management, operational, and technical controls ( i.e., safeguards
or countermeasures) prescribed for an information system to protect the confidentiality,
integrity, and availability of the system and its information.
4. System Availability – Availability means the degree to which a system, sub system or
equipment is operable and in a committable state at the start of a mission, when the mission
is called for at an unknown, i.e., a random, time.
5. Sustainability – Sustainability is a systemic concept, relating to the continuity of commercial
and technology aspects in this context.
6. Reusability – Reusability is the likelihood a technology component can be used again to add
new functionalities with slight or no modification. The ability to reuse relies in an essential
way on the ability to build larger things from smaller parts, and being able to identify
commonalities among those parts.
7. T estability – An adjective meaning “the ability to be tested”
8. T echnology Adequacy – Refers to the sufficiency of the chosen technology to address a
specific business need.
The key areas to be focussed under Basel II requirements are as follows:


specific business need.
The key areas to be focussed under Basel II requirements are as follows:
1. The collection of data (data source and data consolidation) –
- There should be a consistent and qualified process to collect and consolidate data with
proper metadata capture.
- It should be well defined and automated if possible.
- All processes involved should be traceable, accountable and auditable.
2. The storage of data and Basel II related system –
- The storage should be on a robust data infrastructure that allows the financial institution
to perform backup, restore, archive, replicate, high availability, and perform load
balancing when required.
- The application must be designed with security as the underlying core.
- The system must comply with the financial institution’s application and operational
security policies.
- Further the system must be designed with proper error handling and a defined process
under adequate control to cleanup and to recover the system to normal state.
- T echnology used should be in line with the financial institution’s architecture direction.


Directions, Determinations, and Circulars issued to Licensed Specialised Banks  67
3. Data processing and transmission –
- There must be control on all files that are exchanged between systems.
- There must be proper file identification for each file that is exchanged between systems.
- There should be a HASH total for each file that is exchanged between systems, to be
confirmed, if needed, as advised by regulators and internal security standards.
4. Analytical and reporting for end-user consumption –
- Data/report download and manual manipulation is not encouraged, unless justified by
business and exception sought.
- “Fit-for -purpose” reporting and analytical tools should be used in the technical solution.
- There should not be any manual report distribution via e-mail or intranet.
6. Conclusion
Banks are free to develop, choose and purchase their IT systems and software for the Basel II
programme depending on their risk modelling and data warehouse requirements. However, the
Basel Committee has categorically outlined the following Supervisory expectations for the use
of vendor products in IRB processes in their Newsletter No. 8 (March 2006):
1. Banks must be able to document and explain the role of vendor products and the extent to
which they are used within their IRB processes.
2. Banks must be able to demonstrate a thorough understanding of vendor products used in their
IRB processes.
3. V endor products must be appropriate to the bank’s exposures and risk rating methodologies
and suitable for use within the IRB framework.
4. Banks must have clearly articulated strategies for regularly reviewing the performance of
vendor model results and the integrity of external data used in their IRB risk quantification
processes.
5. Further , the supervisors/regulators will only review and assess the acceptability of estimates
based on the system behind the estimates.


68 Directions, Determinations, and Circulars issued to Licensed Specialised Banks
Directions issued by the Monetary Board of the Central Bank of Sri Lanka under Section 76J(1) of the
Banking Act, No.30 of 1988, as amended.
Sgd. B D W A Silva
Senior Deputy Governor
Central Bank of Sri Lanka
Colombo
31 October 2011

BANKING ACT DIRECTION NO. 10 OF 2011
AMENDMENT TO DIRECTIONS ON
MAINTENANCE OF CAPITAL ADEQUACY RATIO
The qualifying criteria for the SME exposures given in paragraph 6.4.3.1.8 ( i)(d) of Schedule I in
Direction 1(2) of the Banking Act, Directions No. 10 of 2007 is amended by replacing with the following
paragraph:
SME Exposures.  i. The maximum credit exposure of the lending bank to an SME shall not exceed
Rs. 200 million.
 ii. The annual turnover of the SME shall not exceed Rs. 600 million.
 iii. The annual turnover should be based on latest available audited financial
statements or certified by a Chartered Accountant or an Approved Accountant
acceptable to the Department of Inland Revenue. In the case of draft financial
statements, the turnover certified by a Chartered Accountant or an Approved
Accountant should be obtained within the year.
 iv. In the case of grant of credit facilities less than Rs. 50 million, the condition
iii above shall not be applicable and banks shall adopt their own internal
mechanism to verify the SME’s annual turnover.


Directions, Determinations, and Circulars issued to Licensed Specialised Banks  69
Directions issued by the Monetary Board of the Central Bank of Sri Lanka under Sections 46(1) and
76(J)(1) of the Banking Act, No.30 of 1988, as amended.
Sgd. Nivard Ajith Leslie Cabraal
Chairman of the Monetary Board and
Governor of the Central Bank of Sri Lanka
Colombo
31 July 2013
BANKING ACT DIRECTION NO. 5 OF 2013
SUPERVISORY REVIEW PROCESS (PILLAR 2 OF BASEL II) FOR
LICENSED COMMERCIAL BANKS AND
LICENSED SPECIALISED BANKS
In the exercise of the powers conferred by Sections 46(1) and 76(J)(1) of the Banking Act, No. 30
of 1988, last amended by the Banking Act, No. 46 of 2006, the Monetary Board hereby issues Directions
No. 5 of 2013 on the implementation of Supervisory Review Process (SRP) for  Licensed Commercial
Banks (LCBs) and  Licensed Specialised Banks (LSBs), respectively,  in accordance with the Basel II
Capital Accord “International Convergence of Capital Measurement and Capital Standards – A Revised
Framework” issued by  the Basel Committee on Banking Supervision of the Bank for International
Settlements in June 2006.
1.1 In terms of Sections 19(7) and 76G(7) of the Banking Act, the Monetary Board
is empowered to determine the capital adequacy ratio to be maintained by every
LCB and LSB, respectively, as far as practicable by adopting the guidelines for
capital adequacy set out by the Bank for International Settlements in Basel.
1.2 In terms of Sections 46(1) and 76(J)(1) 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 LCB and LSB, respectively, regarding the manner in
which any aspect of the business of such banks is to be conducted.
2.1 Commencing from 1 January 2014, every LCB and LSB shall, at all times,
maintain adequate capital to cover its exposure to all risks, notwithstanding that


maintain adequate capital to cover its exposure to all risks, notwithstanding that
it has complied with the requirements of the Banking Act, Directions No. 9 and
10 of 2007 dated 26 December 2007 issued to LCBs and LSBs, respectively.
2.2 In determ ining the adequate capital referred to in Direction 2.1 above, every
LCB and LSB shall consider the requirements specified in the Regulatory
Framework on SRP attached hereto.
3.1 Every LCB and LSB shall develop and implement a sound Internal Capital
Adequacy Assessment Process (ICAAP) in accordance with the requirements
specified in Part II of the Regulatory Framework on SRP attached hereto.Empowerment
under the
Banking Act.
Maintain Adequate
Capital above the
Minimum Capital
Requirement.
Implement
Sound Internal
Capital Adequacy
Assessment
Process.


70 Directions, Determinations, and Circulars issued to Licensed Specialised Banks
4.1 T he Director of Bank Supervision or examiners of the Bank Supervision
Department shall review and evaluate the following, in accordance with
Part III of the Regulatory Framework on SRP attached hereto.
(a) ICAAP;
(b) compliance with the requirements set out in these Directions and the
Regulatory Framework on SRP attached hereto; and
(c) adequacy of capital maintained by each bank.
5.1 The Central Bank of Sri Lanka shall intervene at an early stage to prevent capital
of a bank falling below the minimum requirement, in accordance with Part IV
of the Regulatory Framework on SRP attached hereto.
6.1 Every LCB and LSB shall submit a Board approved ICAAP Document to the
Director of Bank Supervision within six months from the end of its financial
year. For the purposes of these Directions and the Regulatory Framework on
SRP attached thereto, in the case of banks incorporated outside Sri Lanka, the
“Board” shall mean the Head Office or the Regional Office that supervises the
respective bank.
6.2 ICAAP  Document shall be prepared in accordance with the format given in
Appendix I of the Regulatory Framework on SRP attached hereto. However, this
format shall be considered as the minimum requirement and ICAAP Document
of every LCB and LSB shall be comprehensive and relative to its size, nature
of the business and complexity of business activities.Supervisory
Review and
Evaluation
Process (SREP).
Supervisory
Intervention.

Regulatory
Reporting.


Directions, Determinations, and Circulars issued to Licensed Specialised Banks  71
REGULATORY FRAMEWORK ON
SUPERVISORY REVIEW PROCESS
(PILLAR 2 OF BASEL II)
ATTACHMENT TO THE
BANKING ACT,
DIRECTIONS No. 5 of 2013


72 Directions, Determinations, and Circulars issued to Licensed Specialised Banks
CONTENTS
PART I – OVERVIEW
1. Introduction
2. Objectives of Supervisory Review Process (SRP)
3. Principles governing SRP
4. Scope and Applicability
PART II – INTERNAL CAPITAL ADEQUACY ASSESSMENT PROCESS (ICAAP)
5. Developing and maintaining ICAAP
6. The Board of Directors and Senior Management Oversight
  6.1 Board responsibilities for ICAAP
  6.2 Senior management’ s responsibilities for ICAAP
7. Comprehensive assessment of risks
8. Sound Capital Assessment
9. Monitoring and Reporting
10. Internal Controls and Independent review
PART III – SUPERVISORY REVIEW AND EV ALUATION PROCESS (SREP)
11. Key Components
12. Review Methodologies
13. Objectives
14. Coverage
15. Qualitative Assessment
16. Dialogue with the bank
PART IV – SUPERVISORY INTERVENTION
Appendix I


Directions, Determinations, and Circulars issued to Licensed Specialised Banks  73
PART  I  –  OVERVIEW
1. Introduction
1.1 The Basel II capital adequacy framework, seeks to harness best practices in risk management into
the regulatory process, by providing a spectrum of approaches to measure capital adequacy of banks.
The Basel II framework also seeks to provide regulatory capital requirements that are both more
comprehensive and more sensitive to risk, and as such, more closely aligned to the risk appetite of
banks.
 The Basel II framework is based on three mutually reinforcing pillars:
a. Pillar 1: Minimum capital requirements for three major components of risks that banks face:
credit, market and operational risks;
b. Pillar 2: Supervisory Review Process (SRP): Banks’ own assessments of their capital adequacy
and encourage banks to develop and use better risk management techniques in monitoring and
managing their risks; and
c. Pillar 3: Market Discipline: materially increased disclosure requirements.
1.2 The SRP of licensed commercial banks (LCBs) and licensed specialised banks (LSBs) (hereinafter
referred to as “banks”) is conducted to assess their capital adequacy and to determine whether
banks should hold additional capital to cover risks that are not covered or adequately covered by the
minimum capital requirements under Pillar 1 of Basel II.
2. Objectives of SRP
 SRP  is intended to:
2.1 encourage banks to utilise better risk management techniques – the level of risks a bank is exposed
to, and the control environment that will determine the level of capital required to be maintained by
banks;
2.2 enhance the risk-based supervision of banks in order to assess the capital adequacy relative to risks;
2.3 evaluate the bank’s Internal Capital Adequacy Assessment Process (ICAAP) that determines the
level of capital to be maintained against all risks and ensure that banks have adequate capital to
support all risks; and


support all risks; and
2.4 ensure that banks use ICAAP in more general business decisions and budgets, in more specific
decisions such as allocating capital to business units and when evaluating individual credit decision
process.
3. Principles governing SRP
 SRP  is conducted based on the following four key principles provided in the Pillar 2 of Basel II
capital framework:
a. Banks shall have a process for assessing their overall capital adequacy in relation to their risk
profiles and a strategy for maintaining their capital levels (Principle 1 of Pillar 2-SRP).
b. The Central Bank of Sri Lanka (CBSL) as the regulator will review and evaluate bank’s ICAAP
and strategies, as well as its ability to monitor and ensure compliance with regulatory capital
ratios (Principle 2 of Pillar 2-SRP).
c. CBSL  expects banks to operate above the minimum regulatory capital ratios and requires banks
to hold capital in excess of the minimum (Principle 3 of Pillar 2-SRP).


74 Directions, Determinations, and Circulars issued to Licensed Specialised Banks
d. CBSL  will intervene at an early stage to prevent capital from falling below the minimum levels
required to support the risk characteristics of a particular bank (Principle 4 of Pillar 2-SRP).
4. Scope and Applicability
 This Regulatory Framework shall be applicable to banks on both standalone (“Solo”) level, as well
as on the consolidated (“Group”) level.
PART  II  –  INTERNAL CAPITAL ADEQUACY ASSESSMENT PROCESS (ICAAP)
5. Developing and maintaining ICAAP
5.1 Every bank shall develop and maintain a rigorous and well-documented ICAAP proportional to its
operations and risk profile and consistent with prudential requirements.
5.2 ICAAP  of a bank shall include the following five main features.
a. Board and senior management oversight
b. Comprehensive assessment of risks
c. Sound capital assessment
d. Monitoring and reporting
e. Internal controls and independent review
5.3 A  bank shall design its ICAAP according to the size, complexity and business strategies of the
respective bank.
6. The Board of Dir ectors and Senior Management Oversight
6.1 Board responsibilities for ICAAP
a. The Board shall ensure that the bank has in place a strategic plan which clearly outlines its
current and future capital needs, anticipated capital expenditure, desirable capital level, and
external capital sources.
b. The Board shall review and approve the target level and composition of capital, and the process
for setting and monitoring such targets at least, annually.
c. The Board shall ensure that the senior management:
 (i) performs an analysis of the current and future capital requirements of the bank in relation
to its strategic objectives;
 (ii) establishes frameworks for assessing the categories of risks faced by the bank and develops
systems related to these risks to the capital level of the bank;


systems related to these risks to the capital level of the bank;
 (iii) establishes a method for monitoring compliance with internal policies on risk assessment
and the processes related to risks to capital levels; and
 (iv) establishes a strong internal control culture throughout the bank.
d. The Board shall approve and exercise effective oversight over the bank’s stress testing processes.
e. The Board shall review ICAAP  of the bank periodically, at least annually, to:
 (i) assess the level and trend of material risks and their ef fects on capital levels;
 (ii) evaluate the sensitivity and reasonableness of key assumptions used in the capital
assessment measurement system;
 (iii) determine that the bank holds adequate capital against the various risks and is in compliance
with established capital adequacy goals; and


Directions, Determinations, and Circulars issued to Licensed Specialised Banks  75
 (iv) assess the bank’s future capital requirements based on its reported risk profile and make
necessary adjustments to the strategic plan, accordingly.
f. The Board shall ensure that public disclosures are made in the bank’s audited annual report/
audited financial statements, both qualitative and quantitative information, to assist in assessing
the adequacy of bank’s capital commensurate with all material risks the bank is exposed to in
relation to its current and future activities.
g. The Board shall approve the annual ICAAP  document.
6.2 Senior management’s responsibilities for ICAAP
 The senior management shall:
a. ensure the appropriateness of ICAAP  on an ongoing basis;
b. have a good understanding of the design and operation of ICAAP;
c. be responsible for developing a risk management framework that is appropriate in light of the
risk profile and business strategy of a bank and integrating ICAAP with the capital planning and
management processes of the bank. In this regard, senior management shall, at a minimum:
 (i) establish robust policies and procedures to be approved by the Board to identify, measure
and report all material risks;
 (ii) evaluate the level and trend of material risks and their ef fects on capital levels;
 (iii) evaluate the sensitivity and reasonableness of key assumptions used in the capital
assessment and measurement system;
 (iv) determine if the bank holds adequate capital against the risks faced by the bank;
 (v) assess future capital needs based on the risk profile of the bank and propose necessary
adjustments to its strategic plan; and
 (vi) ensure that ICAAP  is subject to annual independent review for robustness and integrity.
d. establish comprehensive and adequate written policies and procedures, to be approved by the
Board, on its stress testing processes taking an active interest in the development and operation


Board, on its stress testing processes taking an active interest in the development and operation
of stress-testing and, allocating sufficient skilled and competent resources to the modelling
function.
e. ensure regular reporting of bank’ s ICAAP to the Board.
f. prepare the annual ICAAP document in accordance with the specified format given in
Appendix I; and
g. submit the Board approved annual document of ICAAP to the Director of Bank Supervision
within six months from the end of the financial year of the respective bank.
7. Compr ehensive assessment of risks
7.1 Bank’ s ICAAP shall identify all material risks, which are arising from both on balance sheet and
off-balance sheet exposures, faced by the bank and measure these risks that can be reliably quantified
under both normal and stressed conditions. ICAAP shall, therefore, address the following risks.
a. Risks captured under Pillar 1: credit, market and operational risks;
b. Risks not fully captured under Pillar 1; concentration risk (credit risk), interest rate/rate of return
risk in the banking book (market risk) and
c. Risk types not covered by Pillar 1: risks which are not specifically addressed under Pillar 1,
which includes liquidity risk, concentration risk, reputational risk, compliance risk, strategic and
business risk, residual risk.


76 Directions, Determinations, and Circulars issued to Licensed Specialised Banks
7.2 A  bank shall be able to identify other external risk factors that may arise from the regulatory, economic
or business environment. In addition, adequate corporate governance and proper risk management
including internal control arrangements constitute the foundation of an effective ICAAP.
7.3 The risk measurement systems shall be sufficiently comprehensive and rigorous to capture the
nature and magnitude of the risks faced by the bank.
7.4 The risks that are not easily quantifiable shall be evaluated using qualitative assessment and
management judgment.
7.5 When measuring risks, comprehensive and rigorous stress tests shall be performed to identify
possible events or market changes that could have serious adverse effects or significant impact on
the bank’s capital and operations.
7.6 In assessing risks, banks shall also consider the applicable Directions issued under the Banking Act.
8 Sound Capital Assessment
 Internal capital allocation and assessment process shall meet the following requirements.
8.1 Banks shall have an explicit Board approved capital plan which states the objectives and the time
period for achieving those objectives, and in broad terms the capital planning process and the
responsibilities for that process.
8.2 The plan shall also lay out how the bank will comply with capital requirements in the future related
to the level of risk, and a general contingency plan for dealing with divergences and unexpected
events such as raising additional capital, restricting business activities or using risk mitigation
techniques.
8.3 The bank shall set capital targets which are consistent with their risk profile, stage of the business
cycle in which the bank is operating, and business plans.
8.4 An internal strategy for maintaining capital levels which should not only reflect the desired level of


risk coverage but also incorporate factors such as loan growth expectations, future sources and uses
of funds, and dividend policy.
8.5 The amount of capital held shall reflect not only the measured amount of risks but also an additional
amount to account for potential uncertainties in risk measurement.
8.6 In assessing capital, a bank shall also evaluate the quality and capacity of its capital to absorb losses.
8.7 The bank shall demonstrate to CBSL that its capital assessment approach is conceptually sound and
that outputs and results are reasonable.
9. Monitoring and Reporting
9.1 The bank shall establish an adequate system for monitoring and reporting risk exposures and,
assessing how the bank’s changing risk profile affects the capital requirements.
9.2 The bank’ s Board and the senior management shall:
a.  receive reports on the bank’s risk profile and capital needs in a manner appropriate to facilitate
the conduct of their responsibilities;
b. evaluate the level and trend of material risks and their ef fects on capital levels;
c. evaluate the sensitivity and reasonableness of key assumptions used in the capital assessment
measurement system;


Directions, Determinations, and Circulars issued to Licensed Specialised Banks  77
d. determine that the bank holds adequate capital against the risks and is in compliance with
established capital adequacy goals; and
e. assess its future capital requirements based on the bank’s reported risk profile and make necessary
adjustments to the bank’s strategic plan, accordingly.
10. Internal Contr ols and Independent Review
10.1 The bank’s internal control structure is essential to the capital assessment process. Effective control
of the capital assessment process includes an independent review, and where appropriate, with the
involvement of internal or external audits.
10.2 The person(s) responsible for the development or implementation of ICAAP shall not be involved
in the independent review.
10.3 The bank shall conduct periodic independent reviews of its risk management processes to ensure
their integrity, accuracy, and reasonableness. Areas that shall be reviewed include:
a. appropriateness of the bank’s capital assessment process given the nature, scope and complexity
of its activities;
b. identification of lar ge exposures and risk concentrations;
c. accuracy and completeness of data inputs into the bank’ s assessment process;
d. reasonableness and validity of scenarios used in the assessment process; and
e. stress testing and analysis of assumptions and inputs.
PART  III  –  SUPERVISORY REVIEW AND EV ALUATION PROCESS (SREP)
11. Key Components
 SREP , which consists of the following key components, shall be carried out by the Director of Bank
Supervision or examiners of the Bank Supervision Department.
a. Review of the bank’ s ICAAP;
b. Review of the bank’ s risk profile;
c. Review of the levels and quality of capital held; and
d. Communication of SREP  results to the bank.
12. Review Methodologies
 SREP  shall involve a combination of:
a. periodic examinations or inspections;
b. continuous supervision;
c. discussions with the bank management;


b. continuous supervision;
c. discussions with the bank management;
d. review of work of internal and external auditors; and
e. periodic reporting.
13. Objectives
 The objective of the review is to:
a. evaluate the adequacy of bank’s internal capital adequacy assessments and strategies, as well as
their ability to monitor and ensure compliance with regulatory capital ratios;


78 Directions, Determinations, and Circulars issued to Licensed Specialised Banks
b. ensure that the bank operates above the minimum regulatory capital ratios and composition of
capital is appropriate for the nature and scale of the bank’s business;
c. identify existing or potential problems and key risks faced by the bank, deficiencies in their
internal control and risk management frameworks, and the degree of reliance that can be placed
on the outputs of ICAAP;
d. intervene at an early stage to prevent capital from falling below the minimum levels required to
support the risk characteristics of the bank;
e. take appropriate supervisory action and regulatory measures if results of this process are not
satisfactory.
14. Coverage
 SREP  will cover a quantitative review of bank’s Pillar 1 inherent risk exposures and Pillar 2 inherent
risk exposures.
15. Qualitative Assessment
 If Pillar 2 risks are not readily quantifiable, the supervisory judgment is to be used with respect to
qualitative assessments of the bank’s ability to contain actual risk exposures within prudent, planned
levels through effective risk governance, oversight, management and control practices.
16. Dialogue with the bank
16.1 SREP  involves an active dialogue with the bank regarding ICAAP, through which CBSL seeks to:
a. gain deeper insights into the bank’ s overall control and risk management framework;
b. establish a closer understanding of how the bank approaches the risks that are not covered under
the minimum capital requirements and the amount of internal capital allocated to them;
c. understand the mechanisms the bank has maintained for identifying, measuring, monitoring,
controlling, mitigating and reporting its risks; and
d. understand whether additional capital on top of that assessed is necessary to cover the banks’
existing risk exposures, as well as future planned sources of capital.


existing risk exposures, as well as future planned sources of capital.
16.2 The dialogue will provide an opportunity for the bank to make appropriate changes to its ICAAP .
16.3 Communication of SREP  results:
a. After completion of the SREP, the Director of Bank Supervision may conduct discussions with
the bank based on the results of the assessment, including any areas of concern which may lead
to an increase in bank’s minimum CAR.
b. The Director of Bank Supervision will explain the outcome of the assessment and recommend
the prompt corrective actions to address the concerns of the bank, if any. If there is a proposed
increase in the capital, the bank will be notified (with the opportunity to make representations)
before the decision is finalised.


Directions, Determinations, and Circulars issued to Licensed Specialised Banks  79
PART  IV  –  SUPERVISORY INTERVENTION
17. Based on the outcome of SREP , CBSL shall intervene at an early stage to:
a. prevent capital from falling below the minimum requirement of the respective bank; and
b. prevent potential impact to the stability of the financial system.
18. Depending on the capita l level, a range of supervisory actions including the following shall be
initiated.
a. moral suasion to encourage the bank to improve their capital positions and levels;
b. improve the bank’ s ICAAP including risk management systems and controls;
c. require the bank to submit a capital restoration plan;
d. impose restrictions on the payment of dividends, business activities, acquisitions, investments
etc.; and
e. require the replacement of the Board and/or the senior management.


80 Directions, Determinations, and Circulars issued to Licensed Specialised Banks
Appendix I
SPECIFIED FORMAT FOR THE PREPARATION OF ICAAP DOCUMENT
1. General
1.1 The purpose of ICAAP document is to inform the Board/senior management and the CBSL of the
ongoing assessment of the bank's risks, how the bank intends to mitigate those risks and how much
current and future capital is necessary having considered other mitigating factors.
1.2 Annual document of ICAAP of a bank shall be prepared in accordance with the contents given in
paragraph 2 below.
1.3 However , CBSL expects there to be a fair degree of variation in the length and format of submissions
since banks’ business and risk profiles differ from each other and ICAAP document should be
proportional to the size, nature and complexity of a bank’s business.
1.4 Use of this format may, therefore, make the review process more efficient for both the bank and
CBSL.
1.5 Base period and financial data of ICAAP document shall be in accordance with the audited financial
data as at the end of the preceding financial year.
1.6 The projected financial data of ICAAP  document should be at least for three financial years.
2. Contents
2.1 Executive Summary
2.2 Background
2.3 Board and Senior Management Oversight
2.4 Risk Governance
2.5 Sound stress testing processes
2.6 Capital Planning
2.7 Projected financial data and assessment of capital
3. Executive summary
 This section will present an overview of ICAAP  methodology and results. This overview will
include:
a. The purpose of the report and the group entities which are covered by ICAAP;
b. Financial forecasts, including the strategic position of the bank, its balance sheet strength, and
future profitability;
c. Regulatory capital management;
d. Regulatory capital assessment - Pillar 1;
e. Internal capital assessment - Pillar 2;
f. Ratio management: How much and what composition of internal capital the bank considers it


f. Ratio management: How much and what composition of internal capital the bank considers it
should hold as compared with the capital adequacy requirement under Pillar 1;
g. Risk management processes and assessment;
h. Descriptions of the capital and dividend plan; the manner in which the bank intends to manage
capital going forward and for what purposes;
i. Stress testing approach; and
j. Details of the approval.


Directions, Determinations, and Circulars issued to Licensed Specialised Banks  81
4. Background
 This section will include the relevant organization structure and business lines, group structure
(legal and operations) and financial data of the bank largely including the profit, dividends, equity,
capital resources held and as compared with regulatory requirements, total assets, total loan and
advances, total deposits, and any conclusions that can be drawn from trends in the data which may
have implications for the bank’s future.
5. Board and Senior  Management Oversight
 This section would provide the following information:
a. Corporate governance structure;
b. Board and senior management oversight;
c. ICAAP  governance structure;
d. Monitoring and controls; and
e. Internal controls and independent review .
6. Risk Governance
 This section will provide the following;
a. Risk appetite;
b. Risk management framework;
c. Regulatory risk assessment (Pillar 1);
 i. Credit risk
 ii. Market risk
 iii. Operational risk
d. Internal risk assessment (Pillar 2);
 i. Concentration risk
 ii. Interest rate risk in the banking book
 iii. Settlement risk
 iv. Liquidity risk
 v . Compliance risk
 vi. Strategic/business risk, and
 vii. Reputation risk
 viii. Residual Risk
7. Sound str ess testing processes
 This section will provide the following details of bank’ s stress testing practices:
a. Overview of the stress testing process
b. Stress scenario/types
c. Discuss the results of stress tests and its impact to the bank capital
d. Risk mitigation or contingency plans across a range of stressed conditions


82 Directions, Determinations, and Circulars issued to Licensed Specialised Banks
8. Capital planning
 This section will provide details of bank’s capital planning and management processes, which, at a
minimum, includes:
a. the bank’s short-term and long-term capital adequacy goals in relation to its risk profile, taking
into account its strategic focus and business plan;
b. the approved capital targets that are consistent with the bank’s overall risk profile and financial
position;
c. the approach for determining the bank’s overall capital adequacy in relation to its risk profile;
and
d. conclusions.
9.	 Projected 	financial	position	and	assessment 	of	capital
 This section will explain Pillar 1 and 2 capital requirements, in respect to;
a. the expected changes to the business profile of the bank, the environment in which it expects to
operate, its projected business plans (by appropriate lines of business), and projected financial
position for the next, three to five years; and
b. given these business plans, this section would also discuss the bank’s assessment as to whether
additional capital is necessary on top of that assessed to cover their existing risk exposures,
as well as future planned sources of capital.


Directions, Determinations, and Circulars issued to Licensed Specialised Banks  83
Directions issued by the Monetary Board of the Central Bank of Sri Lanka under Section 76 J(1) of the
Banking Act, No. 30 of 1988, as amended.
W A Wijewardena
Senior Deputy Governor
Central Bank of Sri Lanka
Colombo
24 April 2009.
DIRECTIONS
BANKING ACT DIRECTION NO. 2 OF 2009
AMENDMENT TO DIRECTIONS ON OWNERSHIP OF ISSUED CAPITAL
CARRYING VOTING RIGHTS FOR LICENSED SPECIALISED BANKS
In the exercise of the powers conferred by Section 76 J(1) of the Banking Act No. 30 of 1988,
last amended by the Banking Act No. 46 of 2006, the Monetary Board hereby issues the following
Direction amending Direction No. 2 of 2007 dated 19 January 2007, issued by the Monetary Board of the
Central Bank of Sri Lanka. This Direction may be cited as the Banking Act Direction No. 2 of 2009.
The following new Direction shall replace Direction No. 4 of the Banking Act Direction No. 2 of
2007:
Exceptions. 4. Ne vertheless, in the case of a licensed specialised bank which requires
restructuring to avoid inadequacy of capital, insolvency or potential failure, the
Monetary Board may, subject to terms and conditions it may deem fit, grant
permission to any of the categories of the shareholders specified in Section
76J(1)(q) to acquire or hold issued capital carrying voting rights in excess of 15
per cent in the licensed specialised bank, subject to the condition that the issued
capital so acquired shall be reduced to 15 per cent within a specified period as
may be determined by the Monetary Board, on a case-by-case basis.