How Basel II will affect banks and their clients Hong Kong Monetary Authority 15 August 2006

1 What does Basel Committee do? Issues guidance on sound / best practice for banks and banking supervision. Standard accepted worldwide and generally incorporated in national banking supervision. Hong Kong, though not a member of the Committee, has been subscribing to its standards. Basel I and now Basel II are a key element of the Basel supervisory approach.

2 The case for a capital framework Financial instability is costly to the economy, such as... -disruption in the distribution of funds; -breakdown in the payment systems; -possibility of international contagion. Therefore, the need for supervision and capital regulation -but the objective should not be to assure that banks will never fail. Capital regulation can have competitive implications -the need to have internationally harmonised rules for internationally active banks competing with each other; -international versus domestic banks.

3 Why capital ? Capital is important because it provides a buffer against losses, i.e. it provides some assurance that a bank will remain solvent even if incurs losses. In the case of a bank being wound-up, the capital should ideally be sufficient to ensure that creditors (primarily depositors) can be paid off from the proceeds, without any charge to the public purse. The strength of the capital adequacy ratio is generally regarded as the best single indicator of a bank’s (or banking system’s) strength, and is therefore important for public/investor confidence.

4 Basel I (1988) Under Basel I AIs are required to maintain capital against credit risk – measured by the capital adequacy ratio (CAR). Capital base CAR = risk-weighted assets Risk-weighted assets = each class of asset claims X risk weights (0%, 20%, 50%, 100%) Minimum CAR to be maintained by AIs is 8%.

5 Shortcomings of Basel I Recent technological advancement, innovations in financial products and further globalisation have underscored the limitations of the Basel I framework, in particular: -risk weightings are too broad-brush and insufficiently risk-sensitive; -it does not address innovation in risk measurement and management practices (e.g. securitization); -many other risks run by banks (e.g. operational risk and interest rate risk in the banking book) are not reflected in the CAR; -little recognition of risk mitigation techniques.

6 Basel II : The Three Pillars Three Pillars Structure Minimum capital requirements Supervisory review process Market discipline  Credit risk  Market risk  Operational risk  AIs’ internal capital adequacy assessment process  supervisory review  enhanced disclosure

7 Objectives of Basel II Greater use of the roles played by bank management (Pillars 1 and 2) and the market (Pillar 3); better align regulatory capital to underlying risk (economic capital); encourage banks to improve risk management capabilities; comprehensive coverage of risks -Pillar 1 : credit, market and operational risk -Pillar 2 : all other risks, aspects of Pillar 1 risks not captured in Pillar 1, and external factors; applicability to a wider range of banks and systems (menu of options).

8 Relationship of the Three Pillars Pillar 1 – A quantitative approach to minimum capital requirement. Pillar 2 - AIs should have a process for assessing their overall capital adequacy; supervisors will review this process and require additional capital if necessary. Pillar 3 – Market participants should have better access to information regarding the credit standing of AIs (i.e. enhanced disclosure). All three pillars are mutually reinforcing.

9 Credit risk approaches Basel I / Basic approach  One size fits all  No capital incentives for better credit risk management Standardized approach Foundation IRB approach  Risk based  Incentive to manage risk Advanced IRB approach Simple Sophisticated Low level of detail High level of detail Little sensitivity to risk High sensitivity to risk

10 Basic approach similar to current Basel I approach; minor definitional changes incorporated (e.g. residential mortgages & commitments); all risk weights are specified by the HKMA (0%, 20%, 50% & 100%); applicable to AIs with small and simple operations (i.e. most RLBs and DTCs) or those with adequate plan to transition to IRB approach; subject to supervisory approval.

11 Standardized approach default option for AIs (most local banks will adopt this approach initially); expanded risk weights (0%, 20%, 35%, 75%, 100% & 150%) used for assessing capital required; uses external ratings (where available); unrated exposures weighted at 100%; 35% & 100% for residential mortgages and commercial mortgages respectively.

12 IRB approaches relies on a bank’s internal ratings system; based on three risk components – -probability of default (PD); -loss given default (LGD); -exposure at default (EAD); PD x LGD x EAD = capital required; separate approaches for each portfolio of assets; subject to supervisory validation and approval.

13 Treatment of business customers Two broad categories : Retail & Corporate apply under two approaches : Standardized approach and Internal Ratings-Based (IRB) approach

14 Retail Exposures Basel IBasel II Standardized ApproachIRB Approach CriteriaNilBorrower: Individual or small business Exposure characteristics:  HK$10mn O/D, instalment loan, lease, term loan, revolving credit etc. Borrower: Individual or small business Exposure characteristics: Exposure to small business (  HK$10mn) Residential mortgages to individual Revolving facilities to individual (  HK$1mn) Other exposures to individual Managed on a pooled basis Risk-weighted amount 100% RW  exposure 75% RW  exposure RW x exposure RW (0% to 1250%) depending on estimates of certain risk parameters

15 Corporate Exposures Basel IBasel II Standardized ApproachIRB Approach CriteriaNil Exposures to corporate (other than included as retail exposures) Risk- weighted amount 100% RW  exposure RW  exposure RW x exposure RW (0% to 1250%) depending on estimates of certain risk parameters Exposure to SMEs (annual turnover  HK$500mn) will generally have a lower risk- weighted amount due to “firm-size adjustment” Rating (e.g. by S&P) RW AAA to AA-20% A+ to A-50% BBB+ to BB-100% B+ to D150% Unrated100%

16 IRB approach risk weights Probability of default Corporates Retail SME (Annual turnover Euro 5mn)

17 Potential implications of Basel II (1) Basis for proactive risk management alongside the development of the customer creditworthiness; greater protection to depositors due to development of a better risk management culture and systems for banks; improved risk management will enhance the banking sector’s ability to offer to customers more sophisticated products such as derivatives;

18 Potential implications of Basel II (2) greater sensitivity to customer risk due to changes in measuring risks, which will allow for better risk- adjusted pricing, with lower rates for better customers; while enhanced risk assessment might affect loan pricing, capital is just one of the factors for credit margin (e.g. competition, cost and efficiency of individual bank and desired minimum margin on assets); enhanced disclosure of information – published CAR will reflect more accurately change in AIs’ risk profile; improvement of shareholder value and public confidence.

19 Timetable Statutory consultation : Banking (Capital) Rules – 3 August to 2 September 2006 Banking (Capital) Rules & Banking (Disclosure) Rules to be published in the Gazette : late October 2006 Negative vetting by the Legislative Council : early November to mid-December 2006 Implementation of both sets of Rules : 1 January 2007 AIs to implement simpler approaches (Basic, Standardized & Foundation IRB) for credit risk calculation as from 1 January 2007 and may adopt the Advanced IRB approach as from 1 January 2008.

20 Closing Remarks Basel II will promote adoption of stronger risk management practices, which will help enhance the safety and stability of the local banking sector. As a major IFC which prides itself on adopting the latest best practices, it is natural for Hong Kong to implement Basel II at the same time as the Basel Committee members. Implementation of Basel II will enhance the reputation and international standing of Hong Kong and our banks. Your timely feedback on the draft Rules will help us to meet the target implementation timetable.