Underlying this situation are challenges many and varied. Overshadowing them all is the risk of contagion from weaknesses in the advanced economies. The high level of sovereign debt at the peripheral eurozone countries, and its potential vicious feedback into economic recession, is now the principal threat to the global recovery. Meanwhile, in the US, it is still unclear whether recent encouraging signs will be sustained. A big concern there is whether public sector deleveraging will play out in the form of a fiscal cliff or a more gradual, manageable fiscal slope. Either way, via budget cuts or continued fiscal uncertainties, the near-term responses will likely continue to hold back private investment and employment. The aggregate risk of all these challenges for us in Asia is clearly a knock-on drag on Asian economies. There are also two important side effects: first, the impact of monetary loosening in advanced economies on consumer and asset prices in Asia. And second, the potential loss of lending for infrastructure projects in Asia as European banks deleverage and retrench. For policymakers, this is a triple-whammy: subdued growth, asset inflation and capital retrenchment. And compounding this are very high levels of uncertainty and volatility, as markets alternate between risk-on and risk-off. All of which makes policy calibration highly challenging and economic forecasting somewhere between extremely difficult and impossible. Position of Hong Kong’s banking system Given this backdrop, it is very important that we understand and monitor the developments in the US and Europe as closely as possible.

Where we continue to have concerns about the internal rating of particular assets, we may commission an opinion from an external credit rating agency in the form of a skilled person review. It should be no surprise that we are paying particular attention to the internal ratings of the securitised notes backed by equity release mortgages. These typically have a high matching adjustment, are complex and relatively large in value. They are subject to credit default and downgrade risks, like any other matching adjustment assets. But the drivers of default and downgrade risks are the risks on the underlying mortgages, such as prepayment, longevity or the exposure to long-term house prices arising from the 9  Article77c 1 (b), Directive 2009/138/EC Solvency II: Matching Adjustment, unrated, illiquid assets and equity release mortgages. Prudential Regulation Authority SS 3/17. 10  7  All speeches are available online at www.bankofengland.co.uk/speeches  7  no-negative-equity guarantee. The essential point of SS 3/17 is that compensation for the risks taken by the insurer, particularly providing a no-negative equity guarantee, should not translate into a matching adjustment benefit on the restructured notes. Moreover, the compensation for risks retained by a firm as a result of the no negative equity guarantee must comprise more than the best estimate cost of the no negative equity guarantee. A best estimate cost of the no negative equity guarantee might be based on assumptions about likely long-term house price growth in excess of risk-free rates, extrapolating for example from historical experience.