How Basel II will affect banks and their clients How Basel II will affect banks and their clients

Hong Kong Monetary Authority

15 August 2006

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What does Basel Committee do?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.

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The case for a capital frameworkThe 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.

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Why capital ?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.

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Basel I (1988)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%.

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Shortcomings of Basel I 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.

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Basel II : The Three PillarsBasel 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

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Objectives of Basel IIObjectives 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).

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Relationship of the Three PillarsRelationship 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.

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Credit risk approaches 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

1111

Basic approachBasic 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.

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Standardized approachStandardized 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.

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IRB approachesIRB 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.

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Treatment of business customersTreatment of business customers

• Two broad categories : Retail & Corporate

• apply under two approaches : Standardized approach

and Internal Ratings-Based (IRB) approach

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Retail ExposuresRetail Exposures

Basel I Basel II

Standardized Approach IRB Approach

Criteria Nil Borrower:

• 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

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Corporate ExposuresCorporate Exposures

Basel I Basel II

Standardized Approach IRB Approach

Criteria Nil Exposures to corporate (other than

included as retail exposures)

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 D 150%

Unrated 100%

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IRB approach risk weightsIRB approach risk weights

0%

20%

40%

60%

80%

100%

120%

140%

160%

180%

200%

0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

Probability of defailt

Ris

k w

eig

ht

Corporates SME 5mn Retail

Probability of default

Corporates Retail SME (Annual turnover Euro 5mn)

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Potential implications of Basel II (1)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;

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Potential implications of Basel II (2)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.

2020

TimetableTimetable

• 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.

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Closing RemarksClosing 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.