Prudential regulationi Relationship with the prudential regulator
The primary responsibility for the prudent management of an AI rests with the board of directors and management itself. The HKMA issues guidance to AIs through its Supervisory Policy Manual. While the Supervisory Policy Manual does not itself have the force of law, any failure to adhere to any of the guidelines set out in it may call into question whether an AI continues to satisfy the minimum criteria for authorisation under the Banking Ordinance.Continuous supervision
The HKMA adopts a continuous supervision policy to detect and address problems at an early stage. Various techniques are used by the HKMA to gather information and to monitor the business of each AI, including:
- on-site and off-site examinations;
- prudential meetings with the senior management;
- meetings with the board of directors;
- cooperation with external auditors; and
- sharing information with other supervisors.
Furthermore, regular statutory returns are required to be submitted to the HKMA.Risk-based approach
The HKMA adopts a risk-based approach to evaluate the safety and soundness of an AI, its risk-management systems and its internal controls. This enables the HKMA to pre-empt any serious threat to the stability of the banking system.
The major types of inherent risks identified by the HKMA are credit, interest rate, market, liquidity, operational, legal, reputational and strategic risks. A risk-management rating is assigned and factored into the management and other relevant components of the CAMEL rating system, which is an internationally recognised framework for assessing capital adequacy, asset quality, management, earnings and liquidity. The output of the CAMEL system is a supervisory rating to reflect the HKMA's view of the overall safety and soundness of the relevant AI.
For a Hong Kong-incorporated AI, the HKMA normally conducts a regular supervisory review once a year. The supervisory review process is a comprehensive assessment of the level of capital that a Hong Kong-incorporated AI should set aside for the major types of inherent risks identified for the purpose of risk-based supervision.
The HKMA has issued rules under the Banking (Capital) Rules5 that prescribe in detail how the capital adequacy of locally incorporated AIs should be calculated. These rules incorporate Basel III technical guidance. In addition, the HKMA's Supervisory Policy Manual module CA-G-5 (Supervisory review process) sets out details of the changes to the supervisory review process that were necessitated by the implementation of the Basel III capital standards. The Banking (Capital) Rules have been amended in previous years to introduce several capital buffers such as the capital conservation buffer, the countercyclical capital buffer and the higher loss absorbency (HLA) requirement. The capital conservation buffer is an additional layer of Common Equity Tier 1 (CET1) capital above the hard minimum capital requirements that is 2.5 per cent of banks' total risk-weighted assets. The countercyclical capital buffer is a further requirement for CET1 capital ranging from zero to 2.5 per cent of risk-weighted assets for banks' private sector credit exposures in Hong Kong when the HKMA determines there is excess aggregate credit growth associated with a build-up of system-wide risk in Hong Kong. The HLA ratio will apply to AIs incorporated in Hong Kong considered by the HKMA to be domestically systemically important (D-SIBs) and globally systemically important (G-SIBs). There are currently no G-SIBs headquartered and incorporated in Hong Kong. They will be obliged to comply with this requirement by maintaining an additional layer of CET1 capital increasing to a range of from 1 per cent to 3.5 per cent of their total risk-weighted assets.
While there are separate regulators for the prudential supervision of securities, insurance, Mandatory Provident Fund schemes and money lending businesses in Hong Kong, the HKMA supervisory review process assesses all the major risks of a banking group, whether arising from banking or non-banking activities.Climate change risk
On 30 December 2021, the HKMA issued Supervisory Policy Manual module GS-1 (Climate Risk Management). The module sets out the HKMA's supervisory expectations for AIs to incorporate climate climate considerations into governance, strategy, risk management and disclosure. The module focuses on governance (responsibilities of board and senior management, oversight of the development and implementation of the AI's climate-related strategy, including setting of goals and actions and risk appetite); climate strategy planning and implementation; incorporation of climate-related risk considerations into the AI's risk management framework (including risk identification and measurement (both at portfolio, counterparty (including clients) and transactional level), monitoring and reporting, control and mitigation); and disclosure (which should be in line with the recommendations of the Taskforce on Climate-related Financial Disclosures). Module GS-1 envisages the management of climate risk via the existing, traditional framework of risk types (credit risk, market risk, liquidity risk, operational and legal risk, reputational risk and strategic risk).Consolidated supervision
The capital adequacy, concentration of exposures and liquidity of a Hong Kong-incorporated AI are supervised on a consolidated basis to enable the HKMA to assess any weaknesses within a banking or financial group that may have an impact on the AI itself, and to take any necessary defensive or remedial actions. When supervising banking groups, the HKMA takes a flexible approach in determining the scope of consolidated supervision. The HKMA considers an AI's banking group to include its immediate holding company, offices, subsidiaries, affiliates and joint ventures, both domestic and foreign. If the AI is the parent company of several subsidiary operations, the HKMA will assess on a solo basis and assess the risks and strengths of the subsidiary operations and practice 'consolidated supervision' for the banking group. If an AI is a subsidiary of a wider group and with a holding company, then the HKMA will conduct solo and consolidated supervision and review the holding company and other companies in the wider group and apply a 'controller group review' approach. Where an AI or its subsidiaries is also engaged in other financial operations such as insurance and securities businesses, the HKMA will work with the other supervisors (i.e., SFC, the Insurance Authority) to ensure effective overall supervision of the banking group. The HKMA will also rely on and cooperate with host banking supervisors to supervise overseas branches and subsidiaries of AIs. Notwithstanding the HKMA's group-wide approach to supervision, the HKMA's role is to supervise the AI as part of the banking group rather than to supervise all the companies falling within the banking group.ii Management of banks
One of the authorisation criteria under the Banking Ordinance is that the HKMA must be satisfied that the chief executive and directors of the applicant company are fit and proper persons to hold their respective positions. The HKMA will have regard to the person's financial status or solvency, education, other qualifications or experience, ability to carry on the regulated activity competently, honestly and fairly, as well as his or her reputation, character, reliability and financial integrity.
The legal and regulatory duties of the management of AIs are detailed in the HKMA's Supervisory Policy Manual modules on corporate governance (CG-1 to CG-7). In particular, Supervisory Policy Manual module CG-1 (Corporate Governance of Locally Incorporated Authorised Institutions) sets out principles adopted by the HKMA in line with the Principles for Enhancing Corporate Governance of the Basel Committee on Banking Supervision (BCBS) and Supervisory Policy Manual module CG-6 (Competence and Ethical Behaviour) sets out the latest developments in enhancing training programmes for banking practitioners in Hong Kong.
The board is ultimately responsible for the conduct of an AI's affairs, but the HKMA recognises that it may be beneficial for supervision of major functional areas to be delegated to certain specialised committees such as an executive committee, credit committee, asset and liability committee, remuneration committee and audit committee. It is also recognised that key functions and policies of an AI that is a subsidiary of another banking institution may be determined and centralised at the holding company level.Outsourcing
The Supervisory Policy Manual module SA-2 (Outsourcing) sets out the HKMA's supervisory approach to outsourcing and the major points that the HKMA recommends AIs to address when outsourcing their activities. The HKMA's main concerns are with accountability, risk assessment, the ability of service providers, the outsourcing agreement, confidentiality of customer data, the degree of control the AI maintains over outsourced activities, contingency planning, access to outsourced data by the HKMA's examiners and the AI's internal and external auditors, and overseas outsourcing.iii Regulatory capital, loss-absorbing capacity and liquidityCapital adequacy ratio
The HKMA must be satisfied that an AI has financial resources that are adequate for the inherent risks in its business to reduce the risk of insolvency. All AIs are required under the Banking Ordinance to maintain minimum levels of share capital. As regards Hong Kong-incorporated AIs, the HKMA's framework for capital adequacy is based on Basel III (which was implemented in Hong Kong on 1 January 2013).
A Hong Kong-incorporated AI is required under the Banking (Capital) Rules to maintain a CET1 capital ratio of at least 4.5 per cent, a Tier 1 capital ratio of at least 6 per cent and a total capital ratio of at least 8 per cent. Branches of foreign banks are not subject to this requirement as primary reasonability lies with the home supervisor but the HKMA will generally require any foreign bank that wishes to establish a branch in Hong Kong to maintain capital levels consistent with the latest applicable capital standards issued by the BCBS.
Under the supervisory review process discussed above, the HKMA may require an AI to have a capital buffer to cater for risks and uncertainties that are not already captured by the three minimum risk-weighted capital ratios. The HKMA has the power under the Banking Ordinance to vary any capital requirement rule applicable to an AI.Leverage ratio
Hong Kong-incorporated AIs must also comply with the minimum leverage ratio set out in the Banking (Capital) Rules. The leverage ratio is a non-risk-based measure of an AI's capital adequacy, introduced as a 'back-stop' to restrict the build-up of excessive leverage in the banking sector and to provide an additional safeguard against model risk and measurement error in the risk-based capital adequacy ratios. The minimum leverage ratio is 3 per cent.Capital buffers
As mentioned in Section III.i, the HKMA has implemented the following capital buffers: the capital conservation buffer, the countercyclical capital buffer and (for domestic systemically important banks (D-SIBs) and globally systemically important banks (G-SIBs)) the HLA requirement.
The capital conservation buffer is an additional band of CET1 capital at 2.5 per cent.
The level of the countercyclical capital buffer is an additional band of CET1 capital base that ranges from zero per cent to 2.5 per cent. The level is determined by the HKMA's analysis on whether there is excess aggregate credit growth associated with a build-up of system-wide risk in Hong Kong. It is an extension of the capital conservation buffer. On 3 February 2023, the HKMA announced the countercyclical capital buffer would remain unchanged at 1 per cent and noted that economic indicators point to continued soft economic activities in Hong Kong in the last quarter of 2022, but uncertainties about the global and domestic economic environment continue to be heightened though there are initial signs of stabilisation in domestic economic activities.
The HLA requirement applies to Hong Kong-incorporated AIs that are designated D-SIBs and G-SIBs. It is also an additional band of CET1 capital base that acts as an extension of the capital conservation buffer. The HLA range (where applicable) is normally between 1 per cent and 2.5 per cent, although there is a top range of 3.5 per cent. On 30 December 2022, the HKMA announced that the total number of D-SIBs remains unchanged at five compared to 30 December 2021. The list of D-SIBs is: HSBC, Bank of China (Hong Kong) Limited, Hang Seng Bank Limited, Industrial and Commercial Bank of China (Asia) Limited and Standard Chartered Bank (Hong Kong) Limited. Of the five banks, the HKMA has designated the highest HLA (2.5 per cent for 2023) to HSBC and the lowest HLA (1 per cent for 2023) to Hang Seng Bank Limited and Industrial and Commercial Bank of China (Asia) Limited. There is currently no Hong Kong-incorporated AI that has been designated a G-SIB.
If a Hong Kong-incorporated AI's capital level erodes to a level falling within the capital conservation buffer zone, the countercyclical capital buffer zone, or, for a D-SIB, the HLA buffer zone, restraints will be imposed on that AI's distributions. A Hong Kong-incorporated AI is expected to discuss with the HKMA if it anticipates that any of its capital levels will fall close to the buffer zones.Loss-absorbing capacity rules
The Financial Institutions (Resolution) Ordinance6 covers resolution, including bank resolution. The Financial Institutions (Resolution) (Loss-absorbing Capacity Requirements – Banking Sector) Rules7 enable the HKMA to prescribe loss-absorbing capacity (LAC) requirements for 'within scope' financial institutions that are Hong Kong-incorporated AIs, and for their Hong Kong-incorporated holding companies or Hong Kong-incorporated affiliated operational entities. Not all Hong Kong-incorporated AIs will be classified as 'within scope' – meaning that not all Hong Kong-incorporated AIs will be subject to the LAC requirements. The LAC consolidation group may differ from the regulatory capital consolidation group. The rules set out how to calculate LAC leverage ratios (both external LAC and internal LAC, and under a solo, solo-consolidated and consolidated basis), capital component ratios and resolution component ratios (which will often be the same as the related capital component ratio). External LAC risk-weighted ratio will, at a minimum, be the sum of an AI's capital component ratio and its resolution component ratio. Internal LAC risk-weighted ratio will be set at a fraction of the external LAC risk-weighted ratio (likely 75 per cent in most cases). There is a requirement for at least a specified portion (likely one-third) of the LAC to be in the form of LAC debt because LAC debt (unlike LAC equity) is not at risk of depletion before bank failure and so provides a fixed quantity of financial resources that can support an orderly resolution. The rules also cover disclosure requirements in relation to LAC and deductions for holding non-capital LAC liabilities.
The Banking (Capital) Rules contain provisions relating to LAC, including a provision that an AI must take into account its minimum LAC requirements, in addition to its minimum regulatory capital requirements, in calculating the CET1 capital remaining available to meet the capital buffer requirement.
Note that capital that counts towards meeting the regulatory capital requirement (i.e., those hard requirements, ignoring the 'softer' capital buffers) will generally count towards meeting a LAC requirement. This means that the new additional burden for a 'within scope' Hong Kong-incorporated AI will likely be the resolution component ratio.Solo and consolidated capital adequacy ratio
In broad terms, the Banking (Capital) Rules impose capital requirements on Hong Kong-incorporated AIs at two levels: on a solo basis and a consolidated basis.
All Hong Kong-incorporated AIs are required to maintain a capital adequacy ratio on a solo basis, which provides a measure of each institution's (including its local and overseas branches) capital strength. A Hong Kong-incorporated AI may apply to the HKMA to include in its capital base, for the purposes of calculation of its solo capital adequacy requirement, the capital invested in any subsidiary that meets the criteria set out in the Banking (Capital) Rules (effectively requiring the subsidiary to be managed by that parent AI) such that the capital adequacy ratio of that institution will be calculated on a 'solo-consolidated basis'.
Where a Hong Kong-incorporated AI undertakes other banking and financial business through subsidiary companies, the HKMA normally also requires the AI to maintain its capital adequacy ratio on a consolidated basis. This is to ensure that the Hong Kong institution's capital position is maintained at an adequate level taking into account its exposures to risks stemming from such subsidiaries. It is usually the practice of the HKMA to set the same minimum capital adequacy ratio requirement at both the solo and consolidated levels, unless the results of the supervisory review process justify otherwise.
Group supervision may also extend to controllers of the AI, including an assessment of controllers' financial resources to provide continuing support to the AI.Composition of capital base
Under the Banking Ordinance, the capital base of an AI is the sum of its Tier 1 capital and Tier 2 capital. Tier 1 capital is the sum of an AI's CET1 capital and its additional Tier 1 capital. The key elements of the CET1 capital of an AI are the AI's CET1 capital instruments; the amount standing to the credit of the AI's share premium account (if any) resulting from the issue of the AI's CET1 capital instruments; the AI's retained earnings and other disclosed reserves; and the amount of minority interests arising from the CET1 capital instruments issued by the consolidated bank subsidiaries of the AI and held by third parties. The Banking (Capital) Rules also set out in detail how an AI's additional Tier 1 capital and Tier 2 capital are to be calculated. In respect of each category of capital, the Banking (Capital) Rules also specify which items are to be excluded from the calculation, as well as which deductions are to be made.Risk-weighted amount
The Banking (Capital) Rules set out approaches that a Hong Kong-incorporated AI can use to calculate its risk-weighted amounts for credit risk, market risk, operational risk and sovereign concentration risk. Each Hong Kong-incorporated AI is expected to choose options for calculating credit risk, market risk and operational risk based on the results of its own detailed feasibility study. However, there is a default approach for each of those risks that every Hong Kong-incorporated AI must adopt unless the prior approval of the HKMA has been obtained for using another approach.
Banks in Hong Kong generally have strong capital bases. The consolidated capital adequacy ratio of Hong Kong-incorporated AIs was well above the 8 per cent requirement under the Banking (Capital) Rules (19.9 per cent as at the end of 2022).Liquidity risk
The risk-based supervisory approach includes the continuous supervision of each AI's liquidity risk. Central to this is an assessment of an AI's ability to maintain adequate liquidity in the event of a liquidity crisis. The HKMA considers the amount of high-quality liquid assets that an AI can readily dispose of or pledge for funding; the results of stress tests on its cash-flow and liquidity positions; and the stability of the AI's funding sources and its contingency measures for dealing with crisis situations.
The Banking (Liquidity) Rules8 implement the Basel III liquidity coverage ratio (LCR) and seek to promote banks' resilience to short-term liquidity risks by ensuring they have sufficient high-quality liquid assets to meet their obligations for at least 30 days under an acute stress scenario.
The LCR applies only to AIs designated by the HKMA as 'Category 1 institutions' under the liquidity rules. Category 1 institutions are those internationally active AIs or larger or more sophisticated AIs that are significant to the general stability of the local Hong Kong banking system or those AIs that have material liquidity risk. Since 1 January 2019, all Category 1 institutions must maintain at all times an LCR of at least 100 per cent. Other AIs not designated as Category 1 institutions (Category 2 institutions) will be subject to the liquidity maintenance ratio (LMR), which is a modified version of the pre-existing liquidity ratio. Since 1 January 2019, all Category 2 institutions must maintain on average in each calendar month an LMR of at least 25 per cent.
A net stable funding ratio (NSFR) and a local core funding ratio (CFR) apply to different categories of AI to ensure their assets are financed with sufficiently stable sources of funding. Since 1 January 2019, all Category 1 institutions must maintain at all times an NSFR of at least 100 per cent unless certain exemptions apply and certain Category 2 institutions (which are designated by the HKMA as Category 2A institutions) must maintain on average in each calendar month a CFR of at least 75 per cent.
Whether incorporated in or outside Hong Kong, the LCR, LMR, NSFR or CFR (as applicable) will apply only to an AI's business in Hong Kong and its local branches (i.e., excluding any subsidiaries or overseas branches of the AI). For a Hong Kong-incorporated AI, the HKMA may require the LCR, LMR, NSFR or CFR (as applicable) to be calculated on a consolidated basis instead of on an unconsolidated basis, or on both a consolidated and an unconsolidated basis.Liquidity of Hong Kong banks
Hong Kong banks' balance sheets have remained liquid in the aftermath of the global financial crisis, notwithstanding persistent challenges arising from the covid-19 pandemic. The consolidated quarterly average LCR of Category 1 institutions in Hong Kong stood at 153 per cent (September 2019), 156.8 per cent (September 2020), 155.5 per cent (September 2021) and 156.3 per cent (September 2022). The average LCR of Category 1 institutions was 156.3 per cent in the third quarter of 2022 – well above the statutory minimum of 100 per cent. The consolidated quarterly average LMR of Category 2 institutions in Hong Kong stood at 54.5 per cent (September 2019), 55.8 per cent (September 2020), 58.2 per cent (September 2021) and 60.5 per cent (September 2022). The average LMR of Category 2 institutions was 60.5 per cent in the third quarter of 2022, well above the statutory minimum of 25 per cent on average in each calendar month.iv Recovery and resolution
The HKMA is a member of the Financial Stability Board (FSB) and has committed in principle to improving the effectiveness of its own resolution regime in light of the FSB policy paper, Key Attributes of Effective Resolution Regimes, published in October 2011 and updated in October 2014. The Financial Institutions (Resolution) Ordinance, which is the primary legislation setting out Hong Kong's resolution regime, establishes a cross-sector resolution regime for relevant financial institutions (including all AIs) with a view to avoid or mitigate the risks otherwise posed by their non-viability to the stability of Hong Kong's financial system.
The HKMA is contributing to the process of drawing up international resolution and recovery plans as a member of the crisis management groups of several G-SIBs.
In addition to the powers given under that Ordinance, the HKMA may also exercise a number of powers under the Banking Ordinance if, inter alia, an AI informs the HKMA that it is likely to become unable to meet its obligations, or that it is insolvent or about to suspend payment. The HKMA may also take such action unilaterally. In these circumstances, the HKMA, after consultation with the Financial Secretary of Hong Kong, may give directions to the AI in relation to its affairs, business and property.
The Supervisory Policy Manual contains a guideline on recovery planning, RE-1, which informs AIs of the key elements of effective recovery planning and sets out the HKMA's approach and expectations in respect of its review of recovery plans. The Banking Ordinance was amended on 2 February 2018 to give explicit statutory backing to recovery planning. The legislation covers the powers of the HKMA to:
- require the preparation and maintenance of a recovery plan;
- impose requirements on an AI to ensure the recovery plan is fit for purpose;
- impose requirements on an AI to revise its recovery plan;
- give directions to implement recovery plan measures under specific conditions;
- require AIs to notify certain trigger events; and
- extend recovery powers to an AI's locally incorporated holding company.
On 7 July 2017, the HKMA issued three codes of practice: Resolution Planning – Core information Requirements (CI-1); Operational Independence of the Monetary Authority as Resolution Authority (RA-1) and The HKMA's Approach to Resolution Planning (RA-2). On 20 March 2019, the HKMA issued the Resolution Planning – LAC Requirements (LAC-1) code of practice.
On 27 August 2021, the Financial Institutions (Resolution) (Contractual Recognition of Suspension of Termination Rights – Banking Sector) Rules came into effect. These Rules require Hong Kong-incorporated AIs (and certain group companies or Hong Kong-incorporated holding companies) to include terms in certain non-Hong Kong law governed contracts to ensure those non-Hong Kong law contracts will be subject to the HKMA's power to require stays on termination rights. The Rules also contain record-keeping requirements. On 22 December 2021, the HKMA issued the code of practice Resolution Planning – Contractual Recognition of Suspension of Termination Rights (ST-1), which provides guidance on how to comply with those rules.
On 5 November 2021, the HKMA issued the code of practice Resolution Planning – Operational Continuity in Resolution (OCIR-1). The code of practice sets out the HKMA's expectations on how an AI should put in place arrangements now to secure continuity (were the AI subject to resolution) of services essential to critical financial functions.v Over-the-counter derivatives
Mandatory reporting of over-the-counter (OTC) derivatives came into effect on 10 July 2015 (although licensed banks were previously reporting OTC derivatives under simplified interim reporting requirements introduced in 2013). The scope of mandatory reporting was expanded on 1 July 2017 and currently covers certain interest rate swaps, non-deliverable forwards, FX derivatives, equity derivatives, credit derivatives and commodity derivatives.
Mandatory clearing (and related record-keeping requirements) of OTC derivatives commenced on 1 September 2016. This first phase of mandatory clearing focused on certain standardised interest rate swaps denominated in US dollars, euros, sterling, Japanese yen or Hong Kong dollars and entered into between 'major dealers' (i.e., AIs, approved money brokers and licensed corporations) or between a major dealer and a 'financial services provider' specified on a list prepared by the SFC and approved by the HKMA. An AI that exceeds the relevant average three-month clearing threshold (currently US$20 billion, which is determined in respect of all outstanding OTC derivatives (other than certain deliverable FX forwards and deliverable FX swaps)) will, if its counterparty is a major dealer that also exceeds the clearing threshold, or if its counterparty is a designated financial services provider, be subject to mandatory clearing and related record-keeping obligations in respect of the relevant interest rate swaps. However, in respect of an AI incorporated outside Hong Kong, the obligations only apply to transactions that are recorded in the Hong Kong books of that AI.
On 11 September 2020, the HKMA revised the Supervisory Policy Manual module (CR-G-14) (Non-centrally Cleared OTC Derivatives Transactions – Margin and Other Risk Mitigation Standards) on margin and other risk mitigation standards for non-centrally cleared OTC derivatives. The margin provisions apply to an AI in respect of certain non-centrally cleared derivatives it enters into with a 'covered entity' (although in respect of an AI incorporated outside Hong Kong, the obligations only apply to the transactions that are recorded in the Hong Kong books of that AI). A covered entity means:
- a financial counterparty, meaning (broadly) a licensed or regulated entity that has, or whose group has, an average aggregate notional amount of non-centrally cleared derivatives for the relevant annual testing period (AANA) exceeding HK$15 billion; or
- a significant non-financial counterparty, meaning a non-financial counterparty that has, or whose group has, an AANA exceeding HK$60 billion.
The requirement to exchange variation margin started from 1 March 2017. The requirement to exchange initial margin has been phased in from that date, with a current AANA threshold for both the AI and its covered entity counterparty of HK$6 trillion, reducing to HK$375 billion with effect from 1 September 2021 and then HK$60 billion with effect from 1 September 2022. This delay follows the deferrals announced by the BCBS and the International Organization of Securities Commissions.