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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
22
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.
33
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.
44
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.
55
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.
77
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.
1313
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)
1818
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;
1919
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.