Transcript Implementation of New Accord in Hong Kong

The Asian Banker Summit 2004
Capital Management After Basel II
Simon Topping
Executive Director (Banking Policy)
Hong Kong Monetary Authority
5 May 2004
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Basel II Influence on Capital Management (1)
• Ideally, under Pillar 2, all banks would have an internal
capital adequacy assessment process (CAAP) – i.e. a
process for assessing how much capital is needed to support
the risks they undertake – and this would determine their
target capital ratio
 Ultimate goal : Economic Capital = Regulatory Capital
• Only the largest banks currently use economic capital
models, but Basel II will provide the impetus for smaller
banks to develop such models
• A gradual evolution of capital management practices among
banks is envisaged
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Basel II Influence on Capital Management (2)
• Other aspects of Basel II will also encourage development
of banks’ capital planning and risk management strategies:
– Availability of more sophisticated approaches to
measuring credit risk, i.e. Foundation and Advanced
Internal Ratings-based (IRB) Approaches
– Greater use of stress-testing for assessing capital
impact arising from business cycles and adverse events
– More focus on non-credit risks in determining capital
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More Comprehensive Recognition of Risk (1)
• Fundamental to effective capital management is a bank’s
ability to identify, measure and control all significant
risks that affect its internal capital assessment
• Under Basel II, focus is not just on credit risk – banks
need to look to improving their risk management and
determination of capital requirements in other areas:
– Operational risk and market risk under Pillar 1
– Other non-credit risks (e.g. interest rate risk, “residual”
operational risk, liquidity risk, litigation and legal risk, strategic
risk and business cycle risk etc.) under Pillar 2
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More Comprehensive Recognition of Risk (2)
• This will encourage banks to put in place a
comprehensive process for identifying and measuring
both credit and non-credit risks in their business and
making a more precise allocation of capital against such
risks
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Greater Diversity of Approaches to Credit Risk
• Basel II provides for the following approaches to measuring
capital charge for credit risk :
– Standardised Approach
– Foundation IRB Approach (banks estimate PD)
– Advanced IRB Approach (banks estimate PD and LGD)
• For banks adopting IRB, estimation of PD and LGD of credit
exposures will enable them to allocate capital against
individual exposures (or groups of exposures) in a more
systematic and precise manner
• Credit risk stress-testing will also play an important role in
internal capital assessment (a specific requirement under IRB)
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Capital Charge for Operational Risk (1)
• Addressing non-credit risks – in particular,
operational risk – may be of a higher priority than
refining credit risk management for some banks
• A specific capital charge for operational risk is
required under Basel II – its impact on banks could be
quite significant. (Some international banks allocated
around 12-18% of capital to operational risk)
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Capital Charge for Operational Risk (2)
• In Hong Kong, our focus is initially on implementation
of the Basel sound practices for operational risk
management rather than advanced measurement
approaches (which are still at a very preliminary
development stage)
• Majority of banks in Hong Kong is expected to adopt
the simpler approaches, i.e. Basic Indicator or
Standardised by end-2006, although development of
data systems capable of being used for AMA
(Advanced Measurement Approaches) purposes will be
encouraged in due course
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Development of CAAP
• To implement Pillar 2, banks will have to demonstrate to
their regulators how they conduct economic capital
allocation
• In practice, while banks will develop their own capital
models and will be actually using such models internally,
the regulator will, at least initially, conduct its own
assessment and set the minimum capital ratio (although the
results of a bank’s CAAP will also be taken into account)
• As a matter of principle, the more effective is a bank’s
CAAP, the more it will be possible for regulators to rely on
this for setting the minimum capital ratio (and forming a
view on the appropriate buffer above the 8% minimum)
over time
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Better Capital Allocation Against Risks
• More precise allocation of capital against risks should
help banks to:
– make more efficient use of capital
– develop appropriate business strategies
– develop more sophisticated risk-adjusted pricing (i.e.
measuring return on capital)
– employ hedging strategies through credit derivatives and
insurance
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Maintenance of Capital Levels
• Currently, many Hong Kong banks hold capital well in excess of
their regulatory minimum. This suggests that factors other than
regulatory requirements are at play (e.g. market expectations)
• However, in principle, the coverage of a greater range of risks
under the Pillar 1 and Pillar 2 capital requirements may enable
banks to reduce the size of this “buffer”
• In the case of banks which currently have very high capital ratios,
there may be scope to reduce the level of capital maintained
• Generally speaking, however, we do not expect to see much
immediate change in overall capital levels upon implementation
of Basel II
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Concluding remarks (1)
• By emphasising the importance of risk management and
risk-sensitive capital requirements, Basel II provides
banks with the incentive to improve risk management
and internal capital allocation
• Basel II also paves the way for banks to develop CAAP
and make more use of economic capital models.
However, regulators are expected to continue to set
minimum capital ratios for banks, as the process of
converging economic capital with regulatory capital will
take time
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Concluding remarks (2)
• More efficient capital management, as well as better
understanding and management of risk, should enhance
the risk-adjusted return of banks
• Nevertheless, individual banks will need to carefully
assess the associated costs and benefits and prioritise
their plans to upgrade capital and/or risk management
practices
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