Cyclicality

inSight

05 Mar 2009

Cyclicality

There may be scope for making regulatory requirements less pro-cyclical.

Readers may have come across the term "pro-cyclicality" being used to describe a situation where regulatory requirements on financial intermediaries have the effect of exaggerating economic cycles. Specific reference has been made to the risk-based capital-adequacy requirements for banks under the Basel II framework in that, in an economic downturn, particularly one associated with sharply higher volatility (and so higher risks) in financial markets, the capital adequacy ratio (CAR) falls even though the portfolios of assets on the books of the banks have not changed. This requires the banks (if they are unable or unwilling to raise new capital) to de-leverage by reducing lending or selling assets in a down market to maintain the desirable CAR, worsening the economic downturn in the process. Indeed, the severity of the current downturn in the global economy may be at least partly attributable to the cyclical, and arguably pro-cyclical, nature of regulatory requirements such as capital adequacy, loan-loss provisioning and valuation, particularly when they interact with leverage.

A number of international standard-setting bodies are currently looking at this subject with the aim of reducing the pro-cyclical effects of regulatory requirements. This will be good for the longer term in promoting greater economic and financial stability. On bank capital and provisioning, it is clearly desirable for banks to build up buffers in the good times that can be drawn upon in times of stress, so that they can continue to lend to credit-worthy customers in the bad times, and avoid creating credit tightness that could affect the viability of customers. This could be achieved either on the initiative of the banks or through prudential supervisory requirements, although competitive forces may make the former more difficult. Whether the standard-setting bodies will come up with internationally acceptable and concrete guidance is uncertain. We are observing progress closely and, where appropriate, will contribute to discussions. Meanwhile, our approach is to try and achieve this through encouraging prudent capital planning by the locally incorporated banks, which are subject to the capital-adequacy requirements of the Banking Ordinance.

Readers may be aware that we require locally incorporated banks to maintain a cushion in their CAR over the statutory minimum of 8% specified in the Banking Ordinance. Although we still do not yet have a formalised structure to vary the size of the cushion in accordance with different phases of the economic cycle — for the simple reason that it is quite difficult to be precise about the turning points of a cycle — what we have done, as I announced in November last year, is to introduce flexibility to reduce the cushion if a need is identified for individual banks. But so far no locally incorporated bank has expressed any interest in using that flexibility, largely because many of them actually have bigger cushions than we have specified. Credit concern is still the main factor restraining lending. This is understandable given the sharpness of the economic downturn in Hong Kong and the even more severe conditions prevailing in the developed markets.

Interestingly, a number of locally incorporated banks have actually seen increases in their capital adequacy ratios. They have, for prudent reasons, de-leveraged along with banks in the rest of the world, thus decreasing the amount of assets, and hence risk, on their books. This is also partly an unintended consequence of the large number of foreign banks in Europe and America receiving support from their governments. Where the locally incorporated banks have exposures to these foreign banks, these exposures carry less risk, at least temporarily, to the extent that they are safeguarded by sovereign guarantees. Whatever the reason, I certainly hope that credit will become more abundant in Hong Kong than would otherwise be the case. I also hope that our counter-cyclical approach over capital adequacy for locally incorporated banks will achieve the same effect.

On the pro-cyclical effects of loan-loss provisioning and valuation, there is less scope for exercising supervisory discretion because of the accounting requirements. But the standard-setting bodies are looking at possible remedies. There is now more support, for example, for dynamic provisioning throughout the cycle and more recognition of the problematic nature of fair valuation (particularly its contribution to increasing financial-sector leverage in the up-swing). I hope constructive modifications for maintaining financial stability will come out soon.

Joseph Yam
5 March 2009

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