1 Basel II Pillar 2 Supervisory Review Process Simon Topping Hong Kong Monetary Authority
2 Outline of Presentation Rationale for Pillar 2 Key principles Banks internal capital adequacy assessment process Supervisory review process Requiring capital above minimum levels Risks covered under Pillar 2 Hong Kong approach to implementation
3 Pillar 2: Supervisory Review of Capital Adequacy Three pillars approach Minimum capital requirements Supervisory review of capital adequacy Market discipline
4 Rationale for Pillar 2 Encourage banks to utilise better risk management techniques Ensure banks have adequate capital to support all risks Focus on internal, not regulatory, capital Accommodate differences between banks
5 Supervisory Review of Capital Adequacy Pillar 2 is based on four key principles: Banks' Own Assessment of Capital Adequacy Supervisory Review Process Capital Above Regulatory Minima Supervisory Intervention Foundation = existing supervisory guidance, especially Core Principles for Effective Banking Supervision
6 Banks Own Assessment of Risk and Capital Adequacy Principle 1 Banks should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels.
7 Banks Own Assessment of Risk and Capital Adequacy The level and sophistication of the capital adequacy assessment process should be tailored to the bank s activities and the risks involved in these activities There is no best practice with regard to the design and implementation of such a process (no one size fits all ) However, there are some key features that should be included in every bank s process
8 Banks Own Assessment of Risk and Capital Adequacy Board and senior management oversight Policies and procedures designed to ensure that the bank identifies, measures, monitors and controls all material risks A systematic, disciplined process: that relates capital to the level of risk that states capital adequacy goals vis-à-vis risk, considering the bank s strategic focus and business plan of internal controls, reviews, and audit to ensure the integrity of the overall management process
Banks Own Assessment of Risk and Capital Adequacy Have an assessment process Which is the firm s responsibility Proportionate Formal, documented and management s responsibility Integrated into the management process and decision-making culture Reviewed regularly Risk based Comprehensive Forward-looking Fit for purpose Produce a reasonable outcome 9
Banks Own Assessment of Risk and Capital Adequacy What factors should management consider? Regulatory ratios and requirements Peer comparisons Expectations of counterparties and rating agencies Business cycle effects Forward-looking stress tests Concentrations of credit and other risks Other qualitative and subjective factors Formal modelling and risk analysis Building value for shareholders 1
1 Supervisory Review Process Principle 2 Supervisors should review and evaluate banks internal capital adequacy assessments and strategies, as well as their ability to monitor and ensure their compliance with regulatory capital ratios. Supervisors should take appropriate supervisory action if they are not satisfied with the result of this process.
1 Supervisory Review Process Traditional methods for monitoring compliance with minimum regulatory capital ratios: On-site examinations Off-site surveillance Meetings with bank management Periodic reporting Review of work of internal and external auditors
1 Supervisory Review Process Renewed focus on supervisors evaluation of process to determine: that target levels of capital chosen are comprehensive and relevant to the current operating environment; that these levels are properly monitored and reviewed by senior management; and that the composition of capital is appropriate for the nature and scale of the bank s business.
1 Capital Above Regulatory Minimum Ratios Principle 3 Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require banks to hold capital in excess of the minimum.
1 Capital Above Regulatory Minimum Ratios Pillar 1 requirements include a buffer for uncertainties that affect the banking population as a whole All banks are expected to operate ABOVE the minimum requirement (i.e. not just at 8%!) Supervisors will need to consider whether the particular features of their banks/markets are adequately covered
1 Capital Above Regulatory Minimum Ratios Means to ensure banks are operating with adequate capital levels: Reliance on a bank s internal capital assessment Establishment of trigger and target ratios Establishment of defined capital categories above minimum ratios (e.g. Prompt Corrective Action ) Higher requirements for outliers
1 Supervisory Intervention Principle 4 Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of a particular bank and should require rapid remedial action if capital is not maintained or restored.
1 Supervisory Intervention Objective Identify as early as possible the potential for serious erosion of the bank s capital position in order to limit risk to depositors and financial system
1 Supervisory Intervention Intervening Actions Determined by law, national policies, case-by-case analysis Moral suasion to encourage banks to improve their capital positions Capital ratios may represent triggers for supervisory action, up to and including the closure of the bank
2 Supervisory Intervention Potential Supervisory Actions Increased monitoring of the bank Requiring the bank to improve its internal capital assessment programme Requiring the bank to submit a capital restoration plan Placing restrictions on bank activities, acquisitions, investments, etc. Restricting the payment of dividends Requiring replacement of senior management and/or the board
2 Specific Aspects of Pillar 2 Interest rate risk in the banking book Significant risk that should be supported by capital Use of bank internal systems economic value relative to capital Apply standardised interest rate shock Banks with significant interest rate risk ( outliers ) should reduce risk, increase capital, or both Operational risk Is Pillar 1 requirement under Basic Indicator or Standardised Approach sufficient (e.g., for banks with low profitability)?
2 Specific Aspects of Pillar 2 Credit concentration risk Single exposure or group of exposures that have potential to produce losses large enough to threaten bank solvency Banks should have internal systems/policies and controls to identify/measure/monitor/control concentrations. Bank should include concentrations, including stress tests, in its internal capital adequacy assessment Other risks IRB stress tests, definition of default, residual risk, securitisation
2 Supervisory Transparency and Accountability Criteria used in Pillar 2 assessments should be made publicly available Factors to be considered in setting target or trigger ratios above the regulatory minimum should be publicly available If capital requirements are set above minimum for an individual bank, supervisors should explain to the bank: The risk characteristics specific to the bank Any remedial action necessary
2 Pillar 2 Issues Potentially Significant Obstacles Legal and regulatory impediments Resources (personnel, training, etc) necessary for effective supervisory review Level playing field Transparency Ability to exercise supervisory judgment
2 Hong Kong Approach: CAAP Each bank should establish a CAAP to fit its own circumstances and needs, having regard to the risk profile and level of sophistication of its operations The CAAP should be risk-based, forward-looking and form an integral part of the bank s management / decision-making process The HKMA would not expect all banks necessarily to have a welldeveloped CAAP by 1 Jan 2007, but they should initiate efforts to put in place the basic elements of the CAAP and make steady progress towards enhancing the process over time Foreign bank subsidiaries may adopt group CAAP which is subject to comparable supervisory standards
2 Hong Kong Approach: SRP Main objectives of the SRP : Ensure banks have adequate capital to support all material risks in their businesses Encourage banks to develop and use better risk management techniques for monitoring and controlling their risks Encourage banks to engage in active capital management, including strategic and capital planning Foster an active dialogue between banks and supervisors regarding fulfilment of capital adequacy and risk management standards
2 Hong Kong Approach: Setting Minimum CARs Legislation gives the MA the power to set minimum CARs on a bank-by-bank basis, in the range of 8-16% (i.e. with a maximum add-on of 8%) Current practice is to require a minimum add-on of 2%, principally to cover operational risk and business cycle risk In the past the process by which individual CARs are set has not very transparent, nor entirely rigorous; in practice, the ratio required was largely a function of the bank s CAMEL rating and its size
2 Hong Kong Approach: New SRP We have developed and tested a new scoring system based around our existing risk-based supervisory system Banks are assessed on 8 risk areas credit, market, interest rate, liquidity, operational, legal, reputation and strategic Their score depends on both the risk level and the quality of their risk management
2 Hong Kong Approach: New SRP The process begins with an assessment of the common factors (via the 13 supporting templates) using a combination of techniques and tools, including quantitative and qualitative assessments, scoring of key indicators and trends, statistical and sensitivity analyses, stress and scenario tests, benchmarking against industry performance and peer group comparison Scores (up to a total of 100) will be allocated to common factors included in the 13 supporting templates
3 Hong Kong Approach: New SRP The total score will be translated into a minimum CAR (up to 16%) according to a mapping table The portion above 8% is the capital add-on reflecting the HKMA s assessment of the AI s overall risk profile and extent of Pillar 2 risks Before arriving at the appropriate minimum CAR, need to assess any AI-specific factors not covered under the scoring system
3 Hong Kong Approach: New SRP The results of the SRP will be discussed with the bank, and will determine both the minimum CAR for the bank and our supervisory priorities The results can also be aggregated across the sector to provide a picture of sectoral risks Banks own CAAPs will be reviewed as part of the SRP, but setting of their minimum CAR will, for the time being, remain driven by supervisory assessment In effect, this approach attempts to apply the same degree of rigour to the Pillar 2 risks as has been applied to the Pillar 1 risks
Risk-based supervision Pillar 1 consideration SRP - Key Assessment Factors Pillar 2 consideration Common factors AI-specific factors Inherent risk System & control CAAP Governance Risk mitigating Risk increasing - Counterparty - Credit Credit default risk concentration risk - Transaction risk - Risk - Adequacy and - Corporate Examples Examples risk (CRM) management effectiveness governance system of CAAP and (compliance - IRB / AMA - Securitisation M arket - Trading risk stress-testing and quality) capability for and credit risk - FX risk - Internal control capability AIs using basic / derivatives system and standardised Operational - Risk of losses - Residual environment - Capital quality approach - Residual risk from internal operational and strength modelling risk (including operations and and legal - Infrastructure to - Insurance cover from Pillar 1 legal risk) external events risks meet business - Capability to recognisable needs withstand risk under AMA - Outliers in Interest rate risk - Interest rate - Interest rate (including stress specific risks risk in trading risk in banking - Other support tests on business - Diversification book book systems cycle risk, access benefits - Other factors (e.g. MIS and anti- to capital market inadequately Liquidity money laundering and strength of - Other factors / not dealt - Liquidity risk risk system) shareholders / providing with under parental support, relief capital Pillar 1 or Strategic etc.) the scoring - Strategic risk risk system Reputation risk - Reputation risk Pillar 1 CAR Scoring result through scorecard and 13 supporting templates Assess on a case-by-case basis (may use peer group comparison) MINIMUM CAR 3
3 Allocation Matrix under Scoring System isk Types Risk level Risk mgt system Allocation of scores under Pillar 2 Systems and controls Internal controls Other support systems Infrastructure Subtotal C A A P Gover nance Total Min CAR required under Basel II Pillar 2 Pillar 1 Total Min CAR converted into economic capital allocation redit 4 5.6 2.8 1.2 0.4 10 10 3 27 2.2% 7.0% 9.2% 58% arket - 2.8 1.4 0.5 0.3 5 4 1 10 0.8% 0.3% 1.1% 7% terest rate 6 2.8 1.4 0.5 0.3 5 3 1 15 1.2% - 1.2% 7.5% iquidity 6 2.8 1.4 0.5 0.3 5 3 1 15 1.2% - 1.2% 7.5% perational 3.5 5.4 2.7 0.9 0.3 9.3 2.5 0.7 16 1.3% 0.7% 2.0% 12.5% egal 0.5 0.2 0.1 0.2 0.2 0.7 0.5 0.3 2 0.1% - 0.1% 0.5% eputation 3 0.2 0.1 0.1 0.1 0.5 2.5 1.5 7.5 0.6% - 0.6% 3.5% trategic 3 0.2 0.1 0.1 0.1 0.5 2.5 1.5 7.5 0.6% - 0.6% 3.5% verall 26 20 10 4 2 36 28 10 100 8% 8% 16% 100%
Sample Case for Illustration (No disclosure of scoring details to external parties) SCORECARD Specific risks not directly / fully captured under Pillar 1 (1) Ref. Scoring Score obtained Maximum Maximum Maximum Current Last Comments score score score period period Credit concentration risk A1 L 0.5 M 2 H 4 L 0.28 Interest rate risk in the banking book A2 L 0.75 M 3 H 6 M 2.30 Liquidity risk A3 L 0.75 M 3 H 6 M 1.44 Residual operational risk A4 L 0.5 M 2 H 4 M 1.40 Reputation risk A5 L 0.375 M 1.5 H 3 H 2.80 Market perception : Weak financial position Strategic risk A6 L 0.375 M 1.5 H 3 H 3.00 No strategic planning; unclear strategic goals Systems and controls (2) Risk management system B1 S 2.5 A 10 W 20 W 15.69 Detailed comments shown in Template B1 Internal control system and environment B2 S 1.25 A 5 W 10 W 7.84 Weak control culture; poor internal audit function Infrastructure to meet business needs B3 S 0.5 A 2 W 4 W 3.15 Incompetent staff; high staff turnover Other support systems B4 S 0.25 A 1 W 2 W 1.31 Inadequate anti-money laundering measures Capital strength and capability to withstand risk (3) Capital adequacy assessment process C1 S 1.25 A 5 W 10 W 10.00 Lack of CAAP Capital strength and capability to withstand risk C2 E 2.25 S 9 U 18 S 7.18 Corporate governance (4) D1 E 1.25 S 5 U 10 U 8.33 Inadequate risk mgt knowledge; poor response to regulatory conerns TAL SCORE OBTAINED ORE CONVERTED INTO MINIMUM CAR SK MITIGATING FACTORS (- %) Nil SK INCREASING FACTOS (+ %) Poor earning ability Credit rating of parent bank low at BB- Country rating of parent bank low at BB- NIMUM CAR RECOMMENDED ISTING MINIMUM CAR SERVATION PERIOD BEFORE ADJUSTING MINIMUM CAR (if necessary) NIMUM CAR APPROVED 64.72 12.5% - 1.5% 0.5% 0.5% 15% 15% N/A 15% Negative ROAE and high provision-to-income ratio tes : L = Low, M = Moderate, H = High S = Strong, A = Acceptable, W = Weak S = Strong, A = Acceptable, W = Weak / E = Excellent, S = Satisfactory, U = Unsatisfactory E = Excellent, S = Satisfactory, U = Unsatisfactory 3
3 Conclusions The three pillars together are intended to achieve a level of capital commensurate with a bank s overall risk profile Starting point and emphasis is bank s assessment Sophistication of capital assessment should depend on size, complexity, and risk profile of the bank Pillar 2 does not require specific, formal, across-the-board capital add-on requirements - a range of approaches is possible Intention is to drive better bank risk management and more risk-focused supervision