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HKMA Seventh
Distinguished Lecture: Discussant Comments by Mr David Eldon
Distinguished Guests, Ladies and Gentlemen: good afternoon. It is indeed an honour to be invited by the Hong Kong Monetary Authority to take part in this prestigious event. That said, there are occasions like this when an audience like you would be better served if a speaker like me stood up and simply said: 'As I wholeheartedly agree with the underlying principles of Basel II, let us move immediately to the question and answer session.' After all, this afternoon’s Distinguished Lecture by Governor Caruana provided a thorough and detailed examination of Basel II. The very sound rationale for it. The innovation and technological advancements that spawned it. The broad-based consultative process behind it. The forward-looking approach built into it. And the multiple benefits which will arise from it. However, as I must justify Joseph’s invitation in some manner, I am going to spend my allotted time commenting on Basel II from the point of view of a practitioner. Not so much the intimate details of the new rules - others are infinitely more qualified to discuss such! But rather I intend to talk about some of the larger related issues which banks like mine face. For the purposes of structure, I will divide my commentary about Basel II into three parts: the good, the bad and - for the lack of a better term - the niggly. First the good. As Jaime eloquently pointed out, there are many positive aspects of Basel II. The flexibility of the new rules to each bank's unique risk profile. The alignment of regulations with the advanced technologies and best practices which are being used by banks today. The recognition that no single directive can serve as an effective motivator for all banks given inherent variations in size and scope. The adoption of a 'three pillar' approach which offers incentives to those who can demonstrate they manage their risks well. Other good things from a practitioner point of view include the fact that these new rules will inevitably advance data collection capabilities. Likewise, industry preparations for Basel II are proving to be a catalyst for enhancement of risk measurement and therefore risk management. Another positive from my perspective - and perhaps one that we all tend to overlook - is the process by which the new rules have been formulated. Over the past several years, the fine-tuning of Basel II has resulted in close and continued consultations between regulators, individual banks, industry groups, and others. In other words, it has necessitated a healthy exchange of ideas which in turn has helped the participants better understand and appreciate the viewpoints of all concerned. Moving onto the second part of my comments. If I was asked to cite the not-so-good aspects of Basel II, I would say the single biggest negative is the cost of implementation. Being I am a Scot and I come from HSBC, all of you probably expected as much! Clearly, no organisation that answers to shareholders is thrilled with the addition of significant costs. And they are significant with some estimates putting the aggregated cost for banks in Asia at almost 10 billion US dollars alone. We, of course, realise that such costs can also be considered an investment. An investment that has the potential to deliver returns. Returns in the form of better risk management practices. Unfortunately, however, such costs come at a time when banks like mine are dealing with a rising regulatory burden on a number of fronts. From Sarbanes-Oxley to the European Financial Services Action Plan to changes in accounting standards to International Financial Reporting Standards to anti-money laundering rules to the subject of our discussion today: Basel II. A rising burden that has prompted some commentators to warn of regulatory fatigue. And others to suggest that there is no doubt "the regulatory pendulum has swung too far" given the multiple initiatives banks have to cope with. As a result, many believe the biggest risk facing banks today is not complex financial instruments nor loan losses nor economic shocks. The biggest risk is regulation. Another not-so-good aspect from our perspective is the fact that the application of the Accord will not be standardised. For example, individual regulators will determine what is considered to be allowable collateral in their particular jurisdiction. The definition of default for retail products is also likely to vary. Amongst the items which are open to national discretion, perhaps the most notable is the coverage of assets required under the Internal Ratings Based Approaches. The United States and Canada will, I understand, require 100 per cent of the assets. Meanwhile, the HKMA is taking a more pragmatic approach of 75 per cent initially, moving to 85 per cent over three years. The Centre for the Study of Financial Innovation, has also highlighted the fact that the new capital rules will apply to "virtually all banks and everything else that moves in Europe." Meanwhile, Basel II will be applied "in its full majesty" - again their words, not mine - to only the 10 largest banks in the United States. Clearly any inconsistent interpretation and implementation of the rules will mean that banks operating in the most liberal jurisdictions gain considerable competitive advantages. For banks operating in multiple jurisdictions - like HSBC - it also means coping with an even more complex regulatory environment. Finally, let me move on to 'the niggly'. Side-issues which may not seem critical but are important points to note nonetheless. Three in particular come to mind. First and foremost, the overall objective of Basel II - at least from my perspective - is to nurture a stronger risk management culture. From which there will be related benefits. One such benefit, as the HKMA has pointed out on previous occasions, is that the new rules "may also translate into lower regulatory capital requirements as the regulator’s degree of comfort with the bank’s risk management practices increases." The key word being ‘may’. Basel II may indeed be a capital saving exercise for others. But given HSBC's distribution of assets across so many jurisdictions and our traditional conservative approach to remaining strongly capitalized, it is not likely to be a capital saving initiative for us on a Group-wide basis. Certainly within some areas - Canada, for example, where we are implementing the IRBA approach - there will be capital savings. Here in Hong Kong, however, we expect any capital savings which may arise will likely be offset by additional capital requirements for operational risk. A second niggly: not all banks are demonstrating the same degree of readiness nor willingness towards Basel II. Banks here in Asia, for example, are generally divided into four categories. Those who are well down the path towards adopting the new capital framework. Those who are lagging and perhaps looking to consolidate to remain competitive. Those who are maintaining a 'watch-and-wait' approach. Watching to see what competitor banks are doing. Waiting to find out the degree of supervisory and market pressures they will face. And finally, there are those who are going along at their own slow pace, seemingly blissfully unaware of progress being made elsewhere. HSBC, for its part, has at any one time some 1,000 people in various places around the world engaged in some aspect of preparing for Basel II. Our aim is straightforward. We intend to derive the maximum business benefits - with emphasis on the plural - from the adoption of Basel II. We recognise, however, that it is an evolutionary process. In Hong Kong, we expect to be 85 per cent compliant over three years. We also realise that it is not feasible to introduce an IRB framework across all 76 jurisdictions in which HSBC operates. There are some areas and portfolios which simply do not warrant an IRB model. And we believe there will need to be pragmatism on the part of regulators as it will take many years to refine information and to become completely comfortable with the numbers that emanate from Basel II. There is evidence to suggest that the Basel Committee already recognises such. As a result, they have built into the process initial capital floors. The third side-issue relates to resources. I think it is safe to say that banks of all sizes face the challenge of finding enough people with the right experience to help implement Basel II, not to mention the many other new rules under Sarbanes-Oxley, IFRS and so forth. Banks, of course, are not alone in this struggle. Some regulators, I suspect, may face similar shortages of qualified individuals. As my allotted time is almost up, let me briefly summarise. From a practitioners' point of view, I do not see many banks deriving many instant benefits from implementing Basel II. I do, however, expect that real benefits will emerge more gradually. This is partly due to the fact it will take time to see the results of the enhanced risk management and measurement processes now being put in place. And partly due to banks, supervisors, industry analysts, and others simply needing time to become completely comfortable as the concepts are put into practice. I do not see all banks in all markets in Asia embracing Basel II. Both because of the complexity of the new rules and because of the diversity within the region. Simply put, there are some banks in some markets in Asia which are still working on implementing basic risk management practices. I do, however, expect certain jurisdictions - Hong Kong being one - to lead the way in January 2007. Others will follow in due course: Australia in 2008. Some will offer the Standardised Approach initially followed by the IRB at a later stage: Thailand in 2009, Malaysia in 2010. A few will likely opt to use Basel II as a reference point - a goal for the future. Finally I do not see Basel II as a cure-all for risks. As Joseph pointed out in a column a while back: no matter how effective risk management systems and supervisory measures are, risks still materialise. Good loans still go unexpectedly bad. I do, however, expect risk management will be one of the defining characteristics by which both banks and banking systems will be judged going forward. Which leads me to one final observation. As I was listening to Jaime talk about Basel II, I was reminded of a comment made by R.M. Gray - a predecessor of mine. During his stint as Chairman of The Hongkong and Shanghai Banking Corporation, Mr Gray told shareholders that: "A bank wants three things - good character, good management and solid resources of its own." Words which are as true today as they were when they were originally said in 1899. Words which also support Jaime’s argument that Basel II does indeed take us back to the future. Back to a more traditional focus on risk.
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