Dear colleagues,
Good morning. On behalf of the HKMA, I would like to extend a
very warm welcome to you all here today to take part in this
outreach event organized jointly by the Basel Committee, the FSI
and EMEAP, focusing on the IRB validation aspect of the Basel II
framework. The event coincides with one of the regular meetings of
the Validation Subgroup of the Basel Committee's Accord
Implementation Group, which was held here over the last two
days.
2. The Validation Subgroup, or the AIGV as it is commonly
called, is one of three subgroups under the AIG that share
information and discuss specific issues related to Basel II
implementation. The AIGV specifically explores issues related to
the validation of systems used to generate the ratings and
parameters that serve as inputs into the internal ratings-based
approach to credit risk.
3. The AIGV has done some excellent work, using the regular AIGV
meetings as an information dissemination platform for members of
this Subgroup to explore various IRB validation-related issues. The
AIGV has also published several high quality supervisory guidance
papers covering topics on validation of low-default portfolios, use
of vendor products, use test and control expectations for
validation under the Basel II IRB framework. These topics, as I
understand, will be discussed this afternoon under the two
scheduled working group sessions. To broaden the geographical reach
of the large pool of useful reference documents on IRB-related
issues produced for its meetings or contributed by the member
jurisdictions, the AIGV has developed an electronic library on eBIS
to store these documents for access by the supervisory
community.
4. The hosting of this event is well timed, as some
jurisdictions have already entered into the implementation phase of
the Basel II IRB framework and other jurisdictions, including many
from Asia, are in the pipeline for the introduction of the
framework for adoption by their banks. The event is therefore a
good opportunity for representatives of jurisdictions which have
yet to adopt Basel II to hear from jurisdictions already
implementing the framework about the emerging issues, and to
facilitate future communications on this topic among participants.
As Chairman of the EMEAP Working Group on Banking Supervision, the
HKMA certainly welcomes the opportunity to host this outreach
event, and would like to thank the AIGV members who have stayed
behind after the regular meeting to provide support.
5. A major innovation of Basel II is that it allows banks to
calculate their regulatory capital requirements using the output of
their internal rating systems, subject to supervisory approval.
Under the IRB Approach, banks employ internal rating systems to
produce estimates of one or more risk components, which are then
used as the key inputs to the calculation of regulatory capital
requirements for credit risk.
6. While there is a case for Asian regulators to perhaps
concentrate their Basel II implementation efforts initially on the
Standardised Approach, they would eventually like to see their
banks, those large ones in particular, adopt the IRB Approach over
time as adopting the IRB Approach can substantially enhance the
quality of risk management of banks. Moreover, Asian regulators
including the HKMA find ourselves in the position of playing host
to many large and internationally active banking groups that
propose to adopt the IRB Approach globally, including their
operations in our jurisdictions. In consequence, we need to develop
plans for the adoption of the IRB Approach in our domestic banking
environment. In doing so, we need to balance the readiness of the
industry and other supervisory priorities versus the desirability
of implementation of the IRB Approach.
7. On readiness of the industry, we believe that there are three
key challenges facing banks in Hong Kong and probably other
jurisdictions in Asia. First, the adoption of the IRB Approach by
banks does not merely involve the use of sophisticated quantitative
tools, but also corresponding advances in banks' risk management
practices, culture, internal control and corporate governance. This
is essentially the underlying and overarching principle of the IRB
and other advanced approaches provided under the Basel II
framework.
8. The Basel II framework makes it clear that a bank should be
allowed to provide its own estimates of the risk components for the
calculation of its regulatory capital requirement only on the basis
of a sound internal control and oversight framework. From our
experience, this represents the primary challenge for some banks as
they may focus only on the quantitative aspects of adopting the IRB
Approach, without taking necessary account of the qualitative
aspects. Without a sound internal control and oversight framework,
these quantitative tools might be employed improperly and generate
incorrect information for credit and management decisions. As such,
the drawbacks brought by the use of sophisticated tools could
outweigh the benefits. Thus, validation standards for the internal
rating systems adopted by banks will need to place as much emphasis
on the qualitative as on the quantitative aspects of
validation.
9. Data issues are another critical challenge facing banks and
involve both quality and quantity aspects. On the quality side, it
appears that the awareness of data integrity generally remains low
on the management agenda. Some banks may still have the
misconception that data management only requires an IT system to
keep the numbers, and does not require senior management attention.
In fact senior management need to take the lead in improving data
quality. Apart from making available the necessary IT
infrastructure and resources, this includes establishing an
appropriate data management program as well as policies, standards
and control mechanisms, and from time to time, emphasising the
importance of data quality to the relevant personnel.
10. On the quantity side, since the notions of internal rating
systems and the quantification of credit risks remain relatively
new to the industry, some banks may have kept the relevant default
and loss data only for recent years. Insufficient data consequently
becomes an obstacle to the implementation of the IRB Approach by
banks, in particular that the data collected so far may not be long
enough to cover a complete business cycle. As such, the stability
of an IRB system under different economic conditions cannot be
meaningfully evaluated. The problem is especially consequential in
Asia, as economic fluctuations in the region have tended to be
faster and greater in magnitude than those in more mature banking
markets.
11. The third challenge banks in Asia may face in adopting the
IRB Approach is the paucity of internal resources necessary for
rating system development and validation. Many banks have relied,
or intend to rely, on external parties such as consulting firms and
model vendors. Employing third-party services can be beneficial in
respect of areas like professional expertise, knowledge transfer,
the utilisation of a more comprehensive data set and assuring
independence in the validation process. However, over-reliance on
external parties does carry certain risks. One example is that
banks may not have the internal expertise to assess the quality of
the rating systems delivered by model vendors.
12. And it is not just the banks that face resource issues, it
is the supervisors as well. In common with supervisors in the more
developed markets, we face the challenge of limited internal
resources and expertise with which to implement the IRB Approach.
Moreover, banks and supervisors are often competing between
themselves for the relevant expertise. In addition, the support to
supervisors in Asia from external parties, such as academia,
vendors, consulting firms and rating agencies, is more limited than
in the developed markets. Finally, both banks and supervisors face
a very steep learning curve in familiarising themselves with the
basic concepts and techniques on which the IRB Approach relies, and
need to become more conversant with these types of risk management
technique.
13. A particularly important issue to consider that is highly
relevant to today's event is the standards that bank supervisors
will apply in deciding whether or not to approve a bank to use the
IRB Approach. To ensure that the capital charges computed by the
IRB systems are sufficient for banks to withstand the credit risks
they have incurred and to absorb the potential losses resulting
from borrower defaults, the estimates of the risk components must
be accurate in capturing the relevant aspects of risk. As a
consequence, validation of banks' estimates of the risk components,
and the underlying internal rating systems, is crucial to the
implementation of the IRB Approach. This is one of the greatest
implementation challenges confronting bank supervisors in Asia,
where the development and understanding of the IRB Approach by
banks is generally still at an early stage.
14. No matter what supervisory approach you take in respect of
IRB validation, it is only one of the major questions to which we
need to find an answer. Banks and their supervisors in Asia are
going to face a variety of challenges ahead in the implementation
of the Basel II IRB framework. Through today's outreach event, I
hope that there will be stimulating discussions on these issues and
that participants will be able to take away ideas that can help
them make the implementation of the IRB framework in their
jurisdictions a success. I also hope that the AIGV, the AIG and the
Basel Committee can take account of the views of the Asian region,
and of the particular issues we face.
15. Thank you.
