CAR and risk management (II)

inSight

18 Mar 2004

CAR and risk management (II)

Capital Adequacy Ratio and Risk Management (II)

The second article in this series explains how the idea of capital adequacy ratio (CAR) has evolved to keep pace with globalisation and other developments in banking business. As part of this process, Hong Kong is preparing to meet the new CAR requirements to be implemented by the end of 2006.

The concept of the CAR is actually quite simple, although the details, having undergone many years of development and refinement, are quite demanding even for experts specialising in risk management. This is how it works. On the asset side of the balance sheet of a bank are loans and other assets that the bank chooses to hold. All these assets involve different degrees of risk that they may become impaired - for example a loan to an SME would generally have a higher level of risk than a loan to a major corporate. What we do as banking supervisor is to assign a risk weighting to different categories of bank assets. Applying those risk weightings to the different mixtures of bank assets of different banks, it is possible to measure the totality of credit risks (risk assets) being taken by a bank at all times. We then require each bank to have capital not less than a certain percentage of the amount of its risk assets - the CAR. The minimum CAR we set for each bank varies, but the statutory minimum, as laid down in the Banking Ordinance, is 8 per cent. However, for all of banks incorporated in Hong Kong we prudently require a minimum CAR of at least 10 per cent and the banks in turn maintain an actual CAR above the minimum we specify for each. The actual average CAR for banks incorporated in Hong Kong is currently 15.4 per cent.

The CAR is of course not our invention. There are international standards governing its calculation, given indeed that banking business is increasingly a global business. The international standards are set by the Basel Committee on Banking Supervision (BCBS) - a G-10 committee that meets regularly at the Bank for International Settlements in Basel. The CAR is the principal element in what is called Basel I, an agreement among the members of the BCBS in 1988 that is voluntarily (some say involuntarily for they have no choice) observed by many other banking jurisdictions, including of course Hong Kong. Since it is a global standard, there is little flexibility to take into account domestic circumstances, even though there may be very good justifications for doing so. As we all know, the default rate of residential mortgages in Hong Kong is historically significantly lower than that in other economies and yet they are internationally assigned a risk weighting of 0.5, which overstates the default rate in Hong Kong's case. Nevertheless, it is prudent to be conservative, even though there are those who believe there is inefficiency in the use of bank capital inherent in such approach.

The BCBS is now deliberating on Basel II, which is a lot more complicated than Basel I. An important improvement in Basel II, compared with Basel I, is that banks will hold capital against a wider range of risks - not just credit risk and market risk as at present, but also operational risk, interest rate risk and other risks. Indeed, banking business and banking risks have become much more complicated with globalisation and the revolution in information technology. There is a need for banking supervisory tools to keep up with changes in the market, to track the risks and ensure that they are prudently managed. But it has also been convincingly argued that, as banking stability serves the interests of the banks as much as of the banking supervisor, the sophisticated ones should be entrusted with designing their own risk management systems. Consequently, Basel II now promises to be of mind-boggling dimensions. Indeed, the consultative documents run into hundreds of pages in technical language.

It is in Hong Kong's interests as a significant international banking centre to get geared up to implement Basel II. We intend to observe the timetable of the major international banking centres and have the mechanism broadly in place by the end of 2006. We already have the initial support of the banking community, which has been diligently following international developments on the subject and making its own preparations. We shall work closely together in the next three years to get this mammoth task done and in a manner that is worthy of Hong Kong's status as an international financial centre. Implementation plans, involving substantial changes to legislation, are now being drawn up, and we shall be in a position shortly to consult all concerned on the best way forward.

 

Joseph Yam

18 March 2004

 

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