How Basel II will affect banks and their clients

1
How Basel II will affect banks and their clients

• Hong Kong Monetary Authority
• 15 August 2006

2
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.

3
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.

4
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 banks (or banking systems) strength, and
  is therefore important for public/investor
  confidence.

5
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.

6
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 Pillars
Three Pillars Structure
Minimum capital requirements
Market discipline
Supervisory review process

• Credit risk
• Market risk
• Operational risk

• AIs internal capital
• adequacy assessment
• process
• supervisory review

• enhanced
• disclosure

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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).

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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.

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Credit risk approaches
Foundation IRB approach
Standardized approach
Advanced IRB approach
Basel I / Basic approach

• One size fits all
• No capital incentives
• for better
• credit risk management

• Risk based
• Incentive to manage risk

Simple
Sophisticated Low level of detail
High level of detail Little
sensitivity to risk High
sensitivity to risk
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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.

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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.

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IRB approaches

• relies on a banks 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.

14
Treatment 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 Exposures
16
Corporate Exposures
17
IRB approach risk weights
SME (Annual turnover Euro
5mn)
Retail
Corporates
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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
  sectors ability to offer to customers more
  sophisticated products such as derivatives

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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.

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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.

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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.