Basel II will bring new and complex capital standards for banks: these will be to the benefit of the financial system, the economy, and the general public.
The Basel Committee on Banking Supervision, the international standard-setter in the field of banking supervision, has recently finalised its revised framework on capital standards for banks (known variously as "Basel II" or "the New Capital Accord"). Getting to this stage has taken several years, for this new framework is extremely complicated, and there have had to be several rounds of painstaking consultation and continuous refinement of the framework to get it right. But now the whole process moves into the implementation phase, with the world's top financial centres - Hong Kong included - aiming to get it put into place by the end of 2006. This might sound like plenty of time, but in fact it is not a lot of time given the very significant changes that will have to be made by the HKMA and by banks themselves. Changes will also be required to the banking legislation, necessitating a Banking Amendment Ordinance: we recently briefed the LegCo Panel on Financial Affairs on this. We have also just put out a detailed set of implementation proposals for consultation with the industry and other interested parties.
But is this just a "technical" issue, or something of wider interest? Speaking personally, I find the whole thing fascinating. One of the key features of Basel II is the increasing use of advanced statistical analysis and financial modelling to measure risk - and as I began my government service as a Statistician this is naturally something I am interested in. I doubt, however, whether many non-statisticians would share my enthusiasm for Basel II on this ground, so is there anything else about it that is worth getting excited about?
The answer to this is "yes". There are a number of reasons why Basel II is "good" for Hong Kong.
First, Basel II has a number of features that will help promote the safety and stability of the banking sector. Capital requirements for credit risk will be more "risk-sensitive", meaning that banks will be required to hold less capital against lending that is low-risk, and more against lending that is high risk. Furthermore, banks will, for the first time, be required to hold capital against "operational risk", the risk of loss from inadequate or failed internal processes, people and systems or from external events. And under the second of Basel II's three "pillars" banks will be required to assess the full range of "other risks" they run and determine how much capital to hold against them. Taking all these things together, capital requirements will be more closely tailored to covering the particular risks each bank runs, which is important for banking stability reasons.
Secondly, a key feature of Basel II is to provide incentives to banks to adopt the latest advances in the field of risk management. Banks which adopt best practices in the management of risk will be "rewarded" with lower capital requirements. The extent to which each bank does this will be a matter for the bank itself to determine. This is another aspect of Basel II I particularly like, as it will give banks the flexibility they need to keep up with latest business practices. So, philosophically, I am in agreement with giving banks more flexibility - and more responsibility - for ensuring their risk management is adequate, although, as banking supervisor, I do not propose to leave them entirely to their own devices - the HKMA will still be looking over their shoulder to make sure we are content with what they are doing.
Thirdly, Basel II will involve banks making greater public disclosure about their business. This, again, is something I very much approve of, as I believe market discipline has an important role to play in reinforcing appropriate behaviour by market participants.
But all that I have said up until now is about how banking stability will benefit from Basel II. Of course, banking stability is a public "good", but how will bank customers, and the economy, benefit directly from Basel II?
The key benefit, I believe, is that by adopting more finely-tuned credit assessment processes, banks will be able to "risk-price" their lending better, meaning that better quality customers should be able to borrow at better rates. Improved credit assessment processes should also make banks better-placed to assess the risk on lending to borrowers such as SMEs, thereby opening up the possibility of greater access to finance for such companies. And more sophisticated risk management should enable banks to offer their customers, and use internally, more sophisticated products such as derivatives. The result of all these should be a financial system which is more efficient, and which facilitates effectively the financing of growth of the economy.
And let us not forget that many members of the public are holders of bank shares. Ultimately, Basel II should help lower banks' bad debt charge and improve profitability and thereby shareholder value.
Of course, it is all very well talking about the potential benefits of Basel II, but there is a lot of work to be done to realise these benefits. We will continue to work closely with the banking industry, in full consultation with LegCo and the public in general, to ensure that the benefits to Hong Kong are maximised - and at the minimum cost.
Joseph Yam
5 August 2004
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