An extract from The Banking Regulation Review, 11th Edition
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 so as 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) Rules 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 domestic banks considered by the HKMA to be systemically important (there are currently no global systemically important banks (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 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.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 to determining the scope of consolidated supervision. As a general rule, the banking group's local and overseas offices and financial subsidiaries are covered. Non-bank companies are included in the consolidation if they undertake financial business such as hire purchase, credit cards or leasing. Where non-bank companies (e.g., securities firms or insurance companies) are adequately supervised by other supervisors, the HKMA will rely heavily on their cooperation to ensure effective overall supervision of the banking group. The HKMA will also consider contagion risk in relation to an AI's holding and sister companies.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 experience, knowledge and skills, as well as his or her reputation and character, competence, soundness of judgement and diligence, whether he or she has a record of non-compliance with non-statutory codes or disciplinary records, his or her involvement as a director in any companies wound up by the court, and his or her business record and financial soundness and strength.
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 Basel Committee on Banking Supervision's Principles for Enhancing Corporate Governance, 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, confidentiality of customer data, the degree of control the AI maintains over outsourced activities, contingency planning, and access to outsourced data by the HKMA's examiners and the AI's internal and external auditors.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 8 per cent. Branches of foreign banks are not subject to this requirement but, based on the HKMA's past practice of generally requiring any foreign bank that wishes to establish a branch in Hong Kong to maintain a capital adequacy ratio of at least 8 per cent, it is likely that the HKMA will continue to require foreign banks to meet the three minimum risk-weighted capital ratios.
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.Capital buffers
The HKMA has implemented the following capital buffers: the capital conservation buffer, the countercyclical capital buffer and, for domestic systematically important banks (D-SIBs), the higher loss absorbency requirement.
The capital conservation buffer is being phased in in equal annual increments. The capital conservation buffer is an additional band of CET1 capital, which was increased to its upper level of 2.5 per cent in 2019.
The level of the countercyclical capital buffer is an additional band of CET1 capital base 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 14 October 2019, the HKMA announced and implemented a reduction of the countercyclical capital buffer from 2.5 per cent to 2 per cent. On 16 March 2020, the HKMA announced and implemented a further reduction of the countercyclical capital buffer from 2 per cent to 1 per cent.
The HLA requirement applies only to D-SIBs. It is also an additional band of CET1 capital base that acts an extension of the capital conservation buffer. On 1 January 2020, the HKMA announced that Hong Kong's list of D-SIBs remains unchanged, covering six AIs: HSBC, Bank of China (Hong Kong) Limited, Hang Seng Bank Limited, The Bank of East Asia, Limited, Industrial and Commercial Bank of China (Asia) Limited and Standard Chartered Bank (Hong Kong) Limited. Each D-SIB will, in accordance with the Basel Committee arrangements, include a higher loss absorbency requirement in the calculation of its regulatory capital buffers. Of the six banks, the HKMA has designated to HSBC the highest HLA (2.5 per cent for 2020) and, to The Bank of East Asia, Limited, Hang Seng Bank Limited and Industrial and Commercial Bank of China (Asia) Limited, the lowest HLA (1 per cent for 2020).
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) Ordinance covers resolution, including bank resolution. On 14 December 2018, the Financial Institutions (Resolution) (Loss-absorbing Capacity Requirements – Banking Sector) Rules were issued and came into operation. The rules 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 will at a minimum be the sum of an AI's capital component ratio and its resolution component ratio. Internal LAC will be set at a fraction of the external LAC (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 since 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)(Amendment) Rules 2018 amend the Banking (Capital) Rules. The amendments include the following:
- 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;
- amendments are made to the capital deduction (or risk-weighting) framework for holding non-capital LAC liabilities;
- amendments are made to the qualifying criteria for recognition of instruments as regulatory capital to mirror the qualifying criteria for LAC debt instruments; and
- new provisions relating to sovereign concentration risk and risk-weightings.
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 various alternative approaches that a Hong Kong-incorporated AI can use to calculate its risk-weighted amounts for credit risk, market risk and operational risk. Each Hong Kong-incorporated AI is expected to choose options based on the results of its own detailed feasibility study. However, there is a default approach for each relevant risk that every Hong Kong AI must adopt unless the prior approval of the HKMA has been obtained for using another approach.
Most banks in Hong Kong use the standardised approach for both credit risk and market risk. For operating risk, the banks are split between the standardised approach and the basic indicator 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 (20.6 per cent in September 2019).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.
Amendments to the Banking Ordinance have been enacted to remove the liquidity ratio from the main body of the legislation and to allow the HKMA to make subsidiary legislation prescribing liquidity requirements to implement Basel III reforms. On 1 January 2015, the Banking (Liquidity) Rules implementing the Basel III liquidity coverage ratio (LCR) came into operation, which sought 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. All category 1 institutions must maintain at all times an LCR of at least 100 per cent from 1 January 2019. 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. All category 2 institutions must maintain, on average, in each calendar month, an LMR of at least 25 per cent.
On 1 January 2018, a new net stable funding ratio (NSFR) and a new local core funding ratio (CFR) were brought into force. These apply to different categories of AI to ensure their assets are financed with sufficiently stable sources of funding. 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 (that are designated as category 2A institutions) must maintain, on average, in each calendar month, a CFR of at least 75 per cent from 1 January 2019.
Whether AIs are 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 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 and, although the ratio decreased slightly in the second half of 2019, the ratio was still well above the statutory minimum of 100 per cent. The consolidated quarterly average LCR of category 1 institutions in Hong Kong stood at 157.3 per cent (September 2018), 152.8 per cent (June 2019) and 153 per cent (September 2019). The consolidated quarterly average LMR of category 2 institutions in Hong Kong stood at 52 per cent (September 2018), 54.6 per cent (June 2019) and 54.5 per cent (September 2019).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, came into operation on 7 July 2017. The Ordinance 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).