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The World Bank Assessing, Managing & Supervising Financial Risk Monday, May 17, 2004 Washington D.C.
Speech Simon Topping Executive
Director (Banking Policy)
Ladies and Gentlemen "Basel II is only applicable to G10 countries - it's of no relevance whatsoever to non-G10 countries, particularly emerging economies". These, I hasten to add, are not my words, but how often have we heard sentiments such as these expressed over the last few years? What's more, how valid are the concerns that Basel II has only limited applicability? My own view is that such concerns are understandable, but a little misguided. While it is certainly true that Basel II has been devised primarily with the G10 in mind, it has - or, at least, many parts of it has - wide applicability. The trick is to be able to separate out which bits of it are of most use to you, in your particular circumstances, and not worry so much about the rest. This might sound a bit heretical if you think that every little detail of Basel II is sacrosanct. And won't the Basel Committee be upset if you don't implement exactly what they've recommended? Won't the World Bank and the IMF regard you as "non-compliant" if you don't have IRB, AMA, and all the other complicated stuff? Well, it might surprise you to know that the Basel Committee explicitly encourages non-G10 countries to adopt a pragmatic approach towards Basel II implementation. And the World Bank and IMF have made it pretty clear that future financial sector assessments will be conducted not on the narrow basis of whether or not a country is in compliance with Basel II per se, but on the broader basis of whether or not its regulatory and supervisory standards are adequate. In fact, at a recent Conference in Hong Kong, the IMF representative went so far as to say that "we will not criticise any emerging market that chooses not to adopt Basel II". So the field would seem to be clear for countries to pick and choose from the menu of Basel II and to assess what particular pieces of the jigsaw should be given priority. In different countries the priorities will vary, depending on such factors as the degree of development of the banking industry, the current state of risk management, and the particular risks facing the industry. Let me say a little about how we see the priorities in Hong Kong, and therefore how we envisage Basel II being implemented. This may help others who are pondering over similar issues. For those who are not familiar with Hong Kong, let me set the scene a little. Hong Kong is a major international financial centre, but is not in the G10 and hence not in the Basel Committee. As an aside, we see this as something of an anomaly, and one which should be addressed by the Basel Committee, but let's leave that debate for another time. The important point is that the Hong Kong market has many similarities with the G10 financial centres, but has its own special characteristics. For example, we have a wide diversity of banks, ranging from the major international banks to smaller local banks. Risk management is adequate, but not necessarily in all cases state-of-the-art, in part because of the historic reliance on collateral in lending. And the operating environment can be quite volatile: in recent years we have seen considerable volatility in rates of economic growth, property values, and interest rates, and elsewhere in the region in exchange rates. How, then should we apply Basel II in such an environment? How can we tailor it to suit the particular circumstances of Hong Kong? But perhaps the first question should be a more fundamental one: should we implement it at all? The answer to this is pretty straightforward in Hong Kong's case. In practice we have no option other than to implement it. It's what's expected of us as a major international financial centre. It's what the major banks want. And, importantly, it's what we, the Hong Kong banking regulator, want. Why is this? I can assure you that it's not simply because we want to be seen to be adopting the best international practices - although this, of course, is a factor. The reason why we're committed to Basel II is that we buy in 100% to the idea that it's a good thing for the banking sector, and therefore for Hong Kong. You see, we anticipate a lot of benefits deriving from improving risk management along the lines set out in Basel II. It will allow for better risk-adjusted pricing, with lower rates for better customers. It will improve the banking sector's ability to offer to customers, and use internally, more sophisticated products such as derivatives. It will increase banks' ability to assess lending to sectors such as SMEs. And it should, in due course, help lower banks' bad debt charge and improve profitability and shareholder value. Taking all this together, there is, therefore , a very persuasive case, we believe, for implementing Basel II in Hong Kong. The way we like to think of it is that Basel II is not about burdening banks with unnecessary regulatory or compliance costs, but of giving them a gentle nudge - or perhaps a not so gentle nudge - in the direction of improving their risk management. They know this makes sense for business reasons, but the process needs to get kick-started somehow. But how do you get the maximum benefit with the minimum cost? How do you get the maximum bang for your bucks? The way we have approached this is to "strip down" Basel II to the key components and then conduct cost-benefit analysis, in close consultation, of course, with the banking industry. The upshot is that we have decided to allow banks considerable flexibility in which options they adopt, and the timing of adoption. We have not mandated that particular banks should adopt particular approaches - all we've stressed is that the degree of sophistication should be commensurate with the risk. I'll run through how things have evolved in three key areas: credit risk; operational risk; and stress-testing. On credit risk, we initially expected that most of the banks would adopt the standardised approach, as use of internal ratings systems such as is necessary to adopt IRB is not very well-developed in the region. But, somewhat to our surprise, we now have eight or nine banks, one-third of the total number, aiming towards IRB. And this includes not just the big international banks but some of the smaller local banks too. What's more, around another third of the banks, which probably will never want to adopt IRB, have nevertheless embarked on building internal ratings systems because they are persuaded of the benefits it will bring in terms of improved credit assessment. So, in other words, the industry has bought into the principle of improving credit risk management by assessing the borrower and not relying so much on collateral. This is quite a step forward, we believe. Next, operational risk. This is another important area, but I think it's fair to say that we - and the Hong Kong banks - are not really persuaded that the most sophisticated approaches on offer, namely the advanced measurement approaches, should be a priority for the time being. The reason for this is that these advanced approaches are still in their infancy, and so we expect most of the banks to focus initially on the less advanced approaches, while at the same time building up their risk management capabilities. For the time being, therefore, we will focus on implementing the Basel paper on sound practices for the management of operational risk; in other words, we will focus more on the "soft factors" such as the governance and control issues rather than the "hard data" requirements. Finally, stress-testing. This, for us, is one of the real key areas in Basel II and, because of the volatility I mentioned earlier, one of particular relevance in Hong Kong's situation. What we have done here, therefore, is to issue fairly detailed supervisory guidance on the stress-testing we expect banks to undertake, to supplement the stress-testing that we ourselves do. We expect the banks to regularly assess their vulnerability to adverse changes in market conditions, and consider, for example, how their asset quality might be affected in an economic downturn, by an upsurge in the write-offs on a particular type of business such as credit cards, or by a fall in property values, or how the value of their securities holdings might be affected by changes in interest rates. Doing this will give them a better understanding of their risk profile and their susceptibility to different types of events, and enable them to assess how much capital they need to hold over and above the standard 8%. In other words, it will be a key part of their Pillar 2 assessment. This, then, is the approach we've taken in some of the key areas of Basel II, and I hope that what I've said will stimulate others to consider how best to approach the implementation issue in their own particular country. Of course, we are not ourselves a standard-setter, although we certainly have no objection if others find it helpful to draw on what we are doing in developing their own thinking. Indeed, those of us who are not members of the Basel Committee - and, more to the point, are not even allowed to take part directly in the implementation discussions in Basel - certainly need to work together as much as possible if we are to make sense of Basel II and determine how to get the maximum value out of it. In Asia, co-operation on supervisory issues, I'm pleased to say, is fairly well-ingrained, and in particular we have a well-established Working Group on Banking Supervision which meets under the auspices of a regional grouping known as EMEAP. But we're all going to need every bit of help we can get on Basel II. So, on top of regional co-operation and, of course, the very helpful assistance being provided by the BIS through the Financial Stability Institute, it's very pleasing to see the World Bank stepping up to the plate and doing things such as organising this workshop. I'm sure there are many more ways in which the Bank, and the Fund too, could play a useful role, particularly in relation to emerging economies, for example in the fields of training and technical assistance, and in helping to migrate to the non-G10 information on the practices and approaches being adopted elsewhere. Such a role, I am sure, is something we would all very much welcome. So, in conclusion, Basel II certainly is relevant to emerging markets. It has global applicability, but it has to be applied pragmatically, and fine-tuned to take account of local circumstances and priorities, so implementation approaches will differ. And, finally, I would stress again the important role that regional and international co-operation has to play. Thank you very much. Hong Kong Monetary Authority
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