Top six HK banks may adopt IRB

As many as six Hong Kong banks may implement the internal ratings-based approach (IRB) to Basel II by the end of 2006, potentially accounting for as much as 50% of Hong Kong's banking assets, says Simon Topping, executive director of banking policy at the Hong Kong Monetary Authority (HKMA).

Speaking at a seminar on the implementation of Basel II organised by the City University of Hong Kong and the Hong Kong Institute of Bankers in January, Topping said that Hong Kong could have among the highest proportion of banks using IRB in the world by 2006. “With US regulators ruling that only the 10 largest banks will adopt advanced IRB, we could be in a situation where we have a higher proportion of the banking business in Hong Kong using advanced IRB in 2006 than the US and possibly most other countries,” he says.

The HKMA has already announced it will not force any of the territory’s financial institutions to adopt any particular approach to Basel II, leaving even the largest banks to decide which of the three approaches to credit and operational risk they will take. However, Topping cautioned small and medium-sized banks against trying to implement the IRB approaches. “IRB is only intended for big internationally active banks. For a small bank to implement IRB is a complete and utter waste of time,” he says.

Nonetheless, every bank in Hong Kong will be required to implement aspects of the IRB approach, regardless of size. For instance, all banks will have to expand the number of categories in their credit ratings systems, make more use of quantitative models, and begin stress testing. “It makes sense for all banks to think about how their business would be affected by events like economic downturn, increases in interest rates and regional shocks, and just try and think about whether their book is actually positioned the way they’d ideally like it to be,” says Topping. “I would expect all banks irrespective of size to have some form of stress-testing programme.”

All banks will also have to start managing a wider array of risks. In fact, those banks with adequate credit risk systems in place should prioritise the setting up of systems for market risk, interest rate risk, business cycle risk, forex risk and liquidity risk, potentially leaving further improvements in credit risk systems until after 2006. “It doesn’t mean you have to have the very latest techniques to monitor forex risk, liquidity risk and interest rate risk, but you do need to have systems commensurate with the risks the banks are running,” says Topping.

Those banks implementing the standardised approach will probably see their capital adequacy ratios fall by an average of 87 basis points, based on results of the third quantitative impact study published in May last year. However, those banks with riskier portfolios may see capital adequacy ratios depleted by as much as 2–3%, says Topping. “Overall, there will be little change in the aggregate figure, but for some banks, even using the standardised approach and adding on the operational risk charge will act as an incentive to manage their book.”

There are no estimates on the capital charges for IRB banks in Hong Kong, but Topping adds that implementing the more advanced approaches may not necessarily result in lower charges for all banks. “You can’t assume that IRB is necessarily going to lead to lower capital requirements. It will in economies where you’ve got very low bad debts, but in Asia, where we seem to have got used to a much higher level of underlying bad debt, IRB may end up costing more capital.”

Asia Risk