Basel II – Hong Kong Perspective (I)

inSight

03 Nov 2005

Basel II – Hong Kong Perspective (I)

This first of two articles on the implementation of Basel II in Hong Kong explains how the new framework will improve the risk management of banks and considers the likely costs.

Regular readers of this column will be familiar with Basel II. The term is used to describe the major revision to the capital adequacy standards of banks, which is being introduced in Hong Kong under the Banking (Amendment) Ordinance passed by the Legislative Council in July this year. The same reforms are being introduced around the world and will help to support the stability of domestic and international banking systems. Over these two weeks, I would like to explain more about how we are implementing Basel II in Hong Kong. I hope to explain why it matters to all of us, not just to the banks, and that what seems to be a complex and potentially costly new framework need not be so if we take a pragmatic approach, and if there is co-operation between the banking industry and the HKMA as supervisor and among supervisors in different jurisdictions. I will do my best to use plain language in discussing what is inevitably a rather technical subject. I hope my thoughts will be of interest to both the banking sector and the general reader.

Let us first remind ourselves what Basel II is about: Put simply, the aim of Basel II is to bring the capital requirements for banks – the amount of capital that they have to hold relative to the amount of money they have lent - more closely into line with the risks they are exposed to, and the risk-management practices they adopt. Including more types of risk into capital requirement and making it more sensitive to risk will make the banking system safer and more stable, and that is what we at the HKMA as banking supervisors care about. Obviously, it is also in the interests of the public and the economy as a whole.

What do I mean by "a pragmatic approach"? I mean that we should consider very carefully the costs and benefits of Basel II implementation, and focus on those bits which yield the greatest benefit for the least cost. We should look for ways to make implementation as cost-effective as possible for the banking industry and make sure it is achievable by small banks as well as large ones. We should also promote consistency among jurisdictions so as to aid implementation by banks which operate in multiple jurisdictions, and provide flexibility to let banks adopt different approaches to implementation. This is what I mean by “a pragmatic approach” – trying to make Basel II implementation easier for all involved by avoiding prescriptive and rigid requirements, and instead being flexible, tailoring requirements to circumstances, and being accommodating of diversity.

Of course it’s easy to say such things and much harder to put them into practice, but let me share with you how we in the HKMA have approached Basel II implementation. I would like to make two points in this connection. First, Basel II is not just some over-complicated regime dreamed up by supervisors. Banking business is about making profits by maximising risk-adjusted return. Better understanding and management of risk can only help banks to achieve this. The improvements in risk management that Basel II requires are therefore not just a regulatory requirement but also a business requirement for the banks themselves. Investment in better risk management will pay off in higher profits to the benefit of shareholders and management as well as making the system stronger, which in turn serves the public interest.

Secondly, in Hong Kong, we have been very sensitive to the concerns of banks over implementation costs. And to help address them, the revised capital framework which we are going to implement here will allow authorized institutions – licensed banks, restricted licence banks and deposit-taking companies - to choose from the full menu of calculation approaches for credit risk allowed for under Basel II. We will also offer an additional simplified approach – the Basic Approach – which is basically a variant of the existing Basel I framework incorporating an operational risk charge, to allow the smaller institutions to make the switch to the revised capital framework without too much disruption.

A key point in our implementation approach is that we have not mandated that particular authorized institutions or types of authorized institutions should adopt a certain approach. We have left it up to the institutions themselves to decide which approach best suits them, based on the costs and benefits, the nature of their business, the type and level of risk involved and the level of risk management needed to address it. We understand that the best approach will vary from institution to institution and we do not want to force institutions into investing in risk management systems that are more sophisticated than they need.

Even so, Basel II does require some significant investment in risk-management systems and IT infrastructure, especially for authorized institutions that wish to adopt the more advanced approaches (for example, the Internal Ratings-based - or IRB - Approach) under Basel II. We have made it clear that these institutions should consider their implementation plans carefully and be realistic in setting schedules and priorities. In particular, the implementation dates for the IRB Approach should not be regarded as deadlines and we have stressed that we encourage institutions to take the necessary time to get their internal rating systems right before implementing them – doing it right is more important than doing it fast. This should help institutions to manage the costs as well as making sure the systems are fully tested and robust before they are introduced.

It’s also worth noting that Basel II does more than just improve the match between capital requirements and the risks that banks assume in the course of their business. It creates an explicit link between capital requirements and how well banks manage those risks. This means that, for the first time, banks can bring about a direct reduction in their capital requirements by demonstrating that they are managing their risks effectively. This incentive will create a virtuous circle in which the banks are encouraged to constantly refine and improve their risk management to bring down their capital requirements.

Next week, I will look at how Basel II might affect competition among banks and how we can try to make sure the playing field remains as level as possible.

 

Joseph Yam

3 November 2005

 

Related Viewpoint Article:

 

Click here for previous articles in this column.

 

Document in Word format

Latest inSight
Last revision date : 03 November 2005