Member Article

Year-end deadline for application to the HKMA to adopt the basic approach and internal rating based approach for credit risk calculation The Hong Kong Monetary Authority ("HKMA") issued a circular ("the Circular") to all Hong Kong incorporated authorised institutions ("AIs") on 7 December 2004, requesting formal applications from AIs that plan to adopt the internal rating based ("IRB") or the basic approach ("Basic Approach") for the assessment of their capital adequacy. This follows from the Basel Committee ("the Committee") on Banking Supervision's issuance of the "International Convergence of Capital Measurement and Capital Standards: a Revised Framework", in June this year, which was endorsed by the Central bank governors and the Group of Ten (G10) countries. This new capital adequacy framework, commonly known as Basel II, sets out details of an agreed revised Framework for measuring capital adequacy, and the minimum standard to be achieved and revises the 1988 Basel Capital Accord. Basel II Basel II is designed to provide options for banks and banking systems worldwide, further to strengthen the soundness and stability of the international banking system while maintaining sufficient consistency that capital adequacy regulation will not be a significant source of competitive inequality among internationally active banks. In brief, the concepts and rationale of Basel II are set out in three pillars: Pillar 1: Minimum capital requirements The revised framework retains the requirement of an 8% capital ratio, and offers banks two methodologies for calculating their capital requirements for credit risk: (1) "Standardised Approach" - similar to the existing approach although risk weightings can be fine-tuned at national discretion and weightings are supported by external credit assessments. (2) "Internal Ratings Based Approach" - allows banks to use their own internal estimates of risk to determine capital requirements, with the approval of their supervisor/ regulator. Pillar 2: Supervisory review The regulators will be expected to evaluate how well banks are assessing their capital needs relative to risk and to take action if appropriate. Pillar 3: Market Discipline To enhance market discipline by requiring increased disclosure to the public. The Committee intends the new framework to be available for implementation in member jurisdictions as of year-end 2006, with further time to implement the most advanced approaches relating to credit risk and operational risk by year-end 2007. Implementing Basel II in Hong Kong Closely adhering to international best standards and practices, HKMA published detailed implementation plans for Basel II in August 2004 ("HKMA Proposal"). According to the HKMA Proposal, the Basel II framework will apply to all financial institutions regulated by HKMA and amendments to the existing banking legislation to implement the changes will be enacted during 2006. The Circular sets out HKMA's efforts to implement the Basel II Pillar 1 capital adequacy requirements in line with the timetable laid down by the Committee. AIs are given the choice of adopting either the Basic Approach or the Foundation IRB Approach as from 1 January 2007, or the Advanced IRB Approach as from 1 January 2008. Whether an AI is able to use the IRB Approach for assessing capital adequacy purposes is subject to prior approval from the HKMA. The AI must satisfy the minimum qualifying criteria, which are set out in the HKMA Proposal. The onus is on an AI's management to validate and ensure the quality of its internal rating systems. The HKMA introduced a third methodology for calculating capital requirements for credit risk - the Basic Approach, which relaxes the requirements for certain institutions to implement the Pillar 1 new capital adequacy requirements. An AI satisfying the following criteria may, with the approval of HKMA, adopt the Basic Approach for calculating credit risks from January 1, 2007: • its total asset size does not exceed HK$10bn and its operations are not complex; or • it intends to adopt the Advanced Internal Ratings Based Approach from January 1, 2008; or • it is able to satisfy criteria for transition to the Internal Ratings Based Approach by not later than the end of 2009. In brief, the Basic Approach will incorporate a credit risk capital requirement calculated in accordance with the existing OECD (Organisation for Economic Co-operation and Development) based framework, with some adjustments. Alternatively, the more sophisticated AIs with definite plans may adopt the Foundation IRB Approach during the transition period from 1 January 2007 to 31 December 2009, or the Advanced IRB Approach as from 1 January 2008. AIs planning to adopt the IRB Approach have more room to choose their own estimation on risk measures, but the qualifying criteria are more stringent, and the AI must satisfy qualitative and quantitative requirements. If an AI fails to demonstrate that it can meet the minimum requirements as set out in the HKMA Proposal, the HKMA may reconsider the institution's eligibility for the Internal Ratings Based Approach and will consider the possibility that the AI should hold additional capital to cover relevant risks. AIs which have no definite plans to adopt an IRB Approach and which have not applied for, or received approval to use, the Basic Approach will by default adopt the Standardised Approach as mentioned above. Phased roll-out of IRB Approach The Basic Approach is also offered to larger, more sophisticated AIs as an option to ensure a smooth transition to implementation of the IRB Approach in 2008/2009. Subject to HKMA approval, an AI may be allowed a phased rollout of the IRB Approach over the three-year period. It would be allowed to use the Basic Approach while transitioning, and the AI would be expected to run the IRB Approach in parallel with the Basic Approach prior to adopting formally Basel II. Deadline AIs wishing to adopt the Foundation IRB Approach in January 2007 or the Advanced IRB Approach in January 2008 are reminded that to qualify an application must be made by completing the IRB recognition request form attached to the Circular and returning it to the HKMA by 31 December 2004. Overall, in Hong Kong the big banks have made good progress implementing Basel II while some of the small local banks continue to lag in their preparations. In China, the China Banking Regulatory Commission has decided not to force banks to implement Basel II. However mainland banks seeking to list overseas will come under pressure to adopt the Basel II regime. For details of the HKMA's Basel II implementation framework, please see "Proposals for the Implementation of the New Basel Capital Adequacy Standards in Hong Kong, HKMA paper", August 2004 and the Addendum published in September 2004, which are set out in the HKMA website, http://www.info.gov.hk/hkma/index.htm.