Simon Topping: Basel II - implications for Hong Kong
Speech by Mr Simon Topping, Executive Director (Banking Policy) of the Hong Kong Monetary
Authority, at the City University of Hong Kong/Oracle Systems Hong Kong Limited "Basel II:
Implications for Hong Kong" Seminar, 5 July, Hong Kong.
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I'd like to start by thanking the City University and Oracle Systems for organising today's Seminar and
for giving me this opportunity to share with you some thoughts on Basel II, and in particular on the
implications for Hong Kong.
The process of devising a New Capital Accord has now been going on for more than four years and it
is still another three and a half years until countries start implementing it. It's clear from this timescale
that what we are talking about here is a very major project indeed, and one which has important
implications for the banking industry. It's very welcome, therefore, to have occasions like this to help
spread the word on what it's all about.
But why such a big deal? What's so wrong with the existing Capital Accord? The answer is simply that,
in the 15 years since it was introduced, things have moved on. The nature of banks' business and the
risks they are running have changed dramatically, and the existing Accord no longer comes up to
scratch - it no longer functions as a mechanism for ensuring that banks hold an amount of capital that
is broadly commensurate with the risks they run. In particular, the current broad-brush treatment of
credit risk means that the capital requirement in respect of credits of widely varying quality is the
same. And though the existing Accord was modified a number of years ago to incorporate capital
requirements in respect of market risk, it doesn't require banks to hold capital against many other risks
they run - for example, operational risk, interest rate risk in the banking book, and business cycle risk.
So there are many good reasons why there should be a Basel II to address these weaknesses in the
current Capital Accord. But while this objective of better matching capital requirements to the risk
taken is certainly very worthwhile, it's really only part of the story. For the aims of Basel II are
somewhat broader than this. Basel II is not about creating some wonderful all-singing all-dancing
system of capital requirements to keep the banking supervisors happy. It's not a case of supervisors
trying to dictate how banks should manage their business.
On the contrary, it's quite the opposite. For Basel II is an attempt to mould supervisory capital
requirements to the ways in which banks actually manage their business. Moreover - and this is the
crucial point - it aims to relate the capital requirement not only to the amount of risk they undertake,
but also to how well they manage that risk. So, in other words, not only will banks get lower capital
requirements in respect of lower risk credits; but they'll also get lower capital requirements if they can
demonstrate that they manage risk well.
It is for this reason that Basel II might perhaps be better thought of not as the second "Capital Accord"
but rather the first "Risk Management Accord". Because it focuses attention not only on the more
accurate measurement of risk, but on the management of risk. Banks looking to reduce their capital
charge will have two choices: either reduce the risk, for example by substituting better risk credits for
lower risk credits, or by reducing positions; or simply manage the risk better. And this will apply not
only to credit risk. Again, to take the example of operational risk, banks will have the option of
investing in more advanced approaches which will translate into lower capital charges.
You may have noticed that I just mentioned banks having options, having choices. This is another key
feature of Basel II. No longer will there be a "one size fits all" approach whereby banks of varying
shapes and sizes are shoehorned into one inflexible system of capital charges. Instead, banks will be
able to choose what approach they take; for example, whether they adopt the standardised approach
or IRB approach for credit risk, and which of the various approaches to operational risk they adopt.
Having said that, the HKMA will of course have its own views on what levels of sophistication of risk
management we would expect to see in different types of banks. While we won't mandate particular
approaches, we will expect to see levels of risk management that are commensurate with the types
and levels of risk being run. So, for example, we won't necessarily expect even a large bank with
significant credit risk to implement advanced IRB. But we would expect a bank of such a type to have
a fairly advanced internal credit rating system. As another example, we would generally expect banks
with a significant level of market risk to implement a models based approach to measuring the risk.
This flexible approach - in contrast to the approach being adopted by some other supervisors, who are
mandating that particular approaches be adopted by particular types of banks - is, we feel, the most
appropriate approach for Hong Kong. In Hong Kong we have a wide variety of banks, RLBs and
DTCs. We have different nationalities. We have different sizes. We have banks that focus on the retail
market, and ones that focus on the wholesale market. We have banks that specialise in mortgage
lending, ones that specialise in SME lending, and ones that are jacks of all trades. It's perfectly
appropriate, therefore, that with such a wide variety of banks there should be a wide variety of credit
risk management and other risk management practices. The real point is whether, given the bank's
particular circumstances, the risk management practices they adopt are adequate. And that, primarily,
is a matter for the bank's management to determine, although we will of course, given our statutory
responsibilities, also have an interest in this.
I stress these points for three particular reasons. First, because I don't want anyone to think that we
are against banks taking risk. We're not. That's the business they're in. We simply want to make sure
they recognise and manage the risk effectively. Second, because I want to make clear that we are not
hell bent on driving banks to invest in unnecessarily sophisticated risk management systems. What's
appropriate will clearly vary from bank to bank, depending on the nature and scale of their business
and the risks they run. Third, because I want to be perfectly clear that Basel II is not some underhand
means of making life difficult for smaller banks by raising the hurdle too high in terms of what they
need to spend on risk management and on regulatory compliance. Indeed, on the contrary, the whole
thing is carefully designed so as to accommodate banks of all shapes and sizes.
So, how will Basel II change banking in Hong Kong? The answer, I would suggest, is that we won't
see any dramatic changes overnight, but we will over time see some re-focusing of how the risks
within banks are addressed, both by banks themselves and by the supervisors. This will be more in
the nature of a gradual evolution than a "big bang". There are really two main strands. The first will be
a more systematic identification of risk, and covering a wider range of risks. The second will be the
increased use of quantitative techniques, including modelling and stress-testing.
Let me talk a little bit about each of these in turn.
First is the more systematic identification of risk, covering a wider range of risks. This is something on
which I would say that Hong Kong is already in many respects quite well advanced. For several years
now the HKMA has adopted what we term a "risk-based supervisory approach". This involves a
number of steps. First, the inherent risks being run by an institution in each of its business lines are
identified. Eight inherent risks are focused on - credit risk, market risk, interest rate risk, liquidity risk,
operational risk, legal risk, reputation risk and strategic risk. These risks are then classified as either
"high", "moderate" or "low", taking into account the current position and likely future developments. The
risk control practices to manage these inherent risks are then evaluated, and classified as "strong",
"acceptable" or "weak". This evaluation takes account of such factors as management oversight,
policies and procedures, risk measurement and internal controls. The final step is to combine the
assessments so as to determine whether, for each business line, the risk controls are adequate given
the level and direction of risk. This helps identify areas where there is an apparent mismatch - for
example where a particular business line is assessed as "high" risk but the risk control is assessed as
"weak". Appropriate follow-up action would then be conducted.
I've gone into quite a lot of detail on this to make the point that the dialogue between the banks and
supervisor in Hong Kong already currently focuses on the full range of risks, even though only a small
sub-set of these risks are currently addressed in the capital framework. So, as I said before, Hong
Kong is quite well advanced in this area.
As time goes on, however, we would expect to see the banks themselves doing more of this analysis
and the supervisors less. Indeed, in time we would expect at least the larger banks to have a fairly
well-developed process for assessing all the risks inherent in their business, the quality of the
management of these risks, and ultimately how much capital they need to hold in respect of these
risks.
The second area I mentioned in which we can expect to see some developments is the increased
used of quantitative techniques, including modelling and stress-testing. Again, this is something that is
already happening, but is something to which Basel II will give added impetus. The most obvious area
for this, of course, is credit risk, where we can expect to see banks making greater use of credit
scoring models, and in particular models to estimate probability of default. It seems likely that only a
very small number of banks in Hong Kong will decide, on the basis of their assessment of the costs
and benefits, to invest immediately in a fully-fledged IRB-compliant system. However, very many
more, I am sure, will want to test the water by starting to make greater use in their credit risk
management process of models to assess PD, and this is something that we in the HKMA will
welcome and, indeed, encourage. Rather than build an elaborate in-house model, many banks may
start by purchasing and adapting a system from an external vendor. Or they may join together with
other banks to share the cost of building models and databases, or establish a relationship with the
academic fraternity. With so many banks, we will probably see a variety of approaches, but I think the
direction is clear. Models are here to stay.
The second important area in which the use of quantitative techniques will, I believe, increase, is the
area of stress-testing. One lesson we have all learned from the Asian Financial Crisis is that the level
of economic activity, asset prices and currency values can fluctuate quite widely, and this can
obviously have a big affect on banks' profitability, capital position, and, ultimately, ongoing viability.
One way of trying to ensure that banks can stand up to such stresses is to conduct regular
stresstesting, in other words to assess how they would be affected in hypothetical stress scenarios. Such
testing is becoming an increasingly integral part of the risk management process within banks and, for
that matter, the supervisory process. For example, if you have a good understanding of the extent to
which your asset quality might be affected by an economic downturn, or how the value of your
holdings of securities might be affected by changes in interest rates, this is valuable information in
helping you manage your risks. So this is a technique that can be very useful indeed, and which I am
sure many banks will want to explore further.
All this talk of greater use of modelling and of quantitative techniques raises, of course, the question of
whether there is sufficient availability within Hong Kong of the necessary expertise and skills. This, I
would suggest, offers many opportunities - not the least, I would add, for our hosts and sponsors
today, as both the academic fraternity and specialist service providers can potentially play an
important role here.
I hope that these thoughts on Basel II have been of interest, and possibly have brought out some
aspects that may not have been picked up on before. From what I have said it should be clear, at the
very least, that Basel II is not some abstract regulatory compliance issue of no real value to the
banking industry. On the contrary, it's based very much on emerging best practices in the risk
management arena globally, and the objective is to try to encourage the wider spread of these best
practices around the banking community worldwide. As regards Hong Kong, embracing the New
Accord can only further strengthen our position as one of the world's leading international financial
centres.