The 2007 Annual Report of the Bank Supervision Department (the Department) highlights five key messages:1.Financial-sector regulators and market commentators are again, as in previous years, questioning the appropriateness of banking institutions’ incentive schemes. Consequently, some thoughts on incentive schemes are highlighted in the introductory section of the report.2.The turmoil caused by the sub-prime mortgage market was a major development in financial markets during 2007. The Department requested a selection of South African banks to provide detailed reports on their exposure to the prevailing risks. The findings were that South African banks were not impacted directly, but indirect effects were observable. 3.The Department, in close co-operation with the Financial Intelligence Centre, continued to monitor banking institutions’ compliance with anti-money laundering and the combating of the financing of terrorism (AML/CFT) legislation. Furthermore, the Department prepared for the Financial Action Task Force on Money Laundering’s (FATF) planned mutual evaluation of South Africa in 2008.4.The process followed in implementing Basel II was a major exercise undertaken over several years. Prior to taking the decision to implement Basel II, the Department considered a range of preconditions that would facilitate the process. This process was characterised by its broad consultative approach; several quantitative impact studies and field tests; amendments to the regulatory and supervisory frameworks; and regular interaction with all South African banking institutions, since Basel II was to be implemented by all banks on 1 January 2008. 5.In 2007 regulatory approval was granted for the acquisition of a material shareholding in one of South Africa’s largest banking groups namely, Standard Bank Group Limited (the SBG), a bank controlling company, by Industrial and Commercial Bank of China (ICBC). The transaction, a US$5,5 billion equity investment in the SBG, resulted in ICBC acquiring approximately 20 per cent of the banking group’s shareholding. This was the second major investment in one of South Africa’s largest banks, the other being the acquisition of a majority shareholding by Barclays Bank plc (UK) in Absa Group Limited in 2005. Contents of the Annual Report 2007Chapter 1In this chapter the following issues, inter alia, are discussed:Overview of trends in the South African banking sectorThe South African banking system remained stable and banks were adequately capitalised during 2007. Banks maintained capital-adequacy ratios above the minimum requirement of 10 per cent. The capital-adequacy ratio increased from 12,3 per cent in December 2006 to 12,8 per cent in December 2007.Growth in the total balance sheet remained strong during 2007. Banking-sector assets increased from R2 075,3 billion at the end of December 2006 to R2 547,0 billion at the end of December 2007, representing an annual growth rate of 22,7 per cent (December 2006: 23,7 per cent). The growth rate slowed down during the first two quarters of 2007, reaching 17,8 per cent at the end of June 2007 before recovering in the remaining two quarters of 2007. Loans and advances, and investment and trading positions were the main contributors to the increase in banking-sector assets during 2007.Throughout 2007 non-bank deposits remained the primary source of funding for the banking sector, and represented 65,1 per cent of total liabilities and capital at the end of December 2007 (December 2006: 65,2 per cent). Total non-bank deposits increased from R1 353,2 billion at the end of December 2006 to R1 657,8 billion at the end of December 2007.Profitability ratios remained strong during 2007. The return on regulatory capital amounted to 18,1 per cent at the end of December 2007, compared with 18,3 per cent at the end of December 2006, while the return on assets equalled 1,4 per cent at both the end of December 2006 and December 2007. The efficiency ratio improved from 58,8 per cent at the end of December 2006 to 56,9 per cent at the end of December 2007.The liquid a