Our Ref: G10/1/7C
29 July 2005
Mr Lund Pui-Chong
Associate Secretary
The DTC Association
Unit 2404, 24/F, Bonham Trade Centre
50 Bonham Strand East
Sheung Wan
Hong Kong
Dear Mr Lund,
Impact of the New Hong Kong Accounting
Standards - Regulatory Reserve
On 11 July 2005, the HKMA circulated a Guidance Note on interim
financial disclosures by locally incorporated AIs in accordance
with module FD-2 of the Supervisory Policy Manual and by overseas
incorporated AIs in accordance with module FD-3. Since then, some
AIs have expressed their concern over the disclosure requirement
relating to the Regulatory Reserve (RR). These concerns centre on
the potential for misinterpretation of the RR by users of financial
statements. Thus, the HKMA considers it appropriate to clarify to
the industry and other interested parties its purpose in requiring
AIs to maintain a RR.
As explained in Mr Topping's letter of 12 December 2004, and our
subsequent Guidance Note of 12 April 2005 on the impact of the new
Hong Kong Accounting Standards (HKAS) on regulatory reporting, the
new HKAS opens up a conceptual gap between "accounting provisions"
and "regulatory provisions". The new accounting standards adopt a
primarily backward-looking "incurred loss" approach to
provisioning. This broadly means that provisions for impairment
must be based on loss experience and only recognised after the
event on which the loss experience is based has occurred. By
contrast, both sound policy and the Banking Ordinance require us to
take in addition a forward-looking view of provisions. Thus we also
expect AIs to provide conservatively against losses which, based on
historical experience, are likely to occur at some point in the
future, but may not yet be evident.
One practical consequence of the conceptual difference between
the accounting and regulatory approaches to provisioning has been
the disappearance of the concept of a general provision. This has
created the potential for substantial write-backs of provisions
without a corresponding improvement in AIs' asset quality.
The HKMA does not consider such write-backs to be consistent
with prudent banking practice, as any changes in provisioning
levels should be explicitly linked to changes in asset quality.
Thus the HKMA's primary objective in requiring a RR has been to
ensure that the accounting changes, in and of themselves, do not
result in a reduction to the overall level of provisions held by
AIs. In other words, the RR is a supervisory tool to bridge the gap
between the accounting and regulatory concepts of provisioning and
neutralise the effect of accounting changes on banks' provisioning
levels. The only effect of the RR for capital adequacy purposes is
to transfer a portion of reserves from tier 1 capital and to
redesignate them as tier 2.
In discussing with individual AIs the level of RR, we have been
guided by the principle that it should broadly correspond to the
difference between the former general provision and the collective
impairment allowance, which we have accepted carries some features
of a general provision under HKAS 39, taking into account any other
relevant changes, such as an AI's asset quality, and credit risk
management practices, in the interim.
Given that the concept of expected loss will remain important in
the Basel II Framework, over the longer term one objective of this
policy is to create incentives for AIs to adopt more sophisticated
approaches to setting provisions. As credit risk models become more
widely used and more sophisticated, and thus better predictors of
actual losses, we would expect the RR to gradually come to form a
less significant component in each AI's approach to
provisioning.
I trust this explanation will help clarify the way in which the
RR ought to be interpreted. In requiring AIs to set aside a RR we
have not departed significantly from our previous policy. The RR
should not be seen as an extra buffer for credit risk, over and
above our existing capital requirements. Nor, given its method of
calculation, can it be considered to be a proxy for the HKMA's
supervisory assessment of a particular AI.
If there are additional questions regarding the issues in this
clarification, please contact either me at 2878-8045 or Ms Theresa
Kwan at 2878-1093.
I am writing in similar terms to the Hong Kong Association of
Banks and Hong Kong Institute of Certified Public Accountants.
Yours sincerely,
Michael Taylor
Head, Banking Policy
