1. Lecture Objectives To discuss the importance of regulating financial institutions To explain the Liquidity Ratio set out in the Banking Ordinance To explain the Capital Adequacy Ratio set out the Banking Ordinance To describe the reporting of Market Risk Exposures by Authorized Institutions

2. Regulations of Financial Institutions (i) to ensure the safety of deposited funds (ii) to ensure the stability of the financial system (iii) to protect depositors and borrowers from the monopoly power of financial institutions (iv) to increase the efficiency by healthy competition

3. Regulations of Financial Institutions The Banking Ordinance provides the legal framework for banking supervision in Hong Kong. The Banking (Amendment) Ordinance 1999 was enacted to bring Hong Kong’s framework of banking supervision fully in line with the core principles of the Basle Committee on Banking Supervision.

4. Regulations of Financial Institutions Authorized institutions have to comply with the provisions of the Banking Ordinance which require them to maintain adequate liquidity and capital adequacy ratios, to submit periodic returns of the required financial information to the Hong Kong Monetary Authority, to adhere to limitations on loans to any one customer or to directors and employees, and to seek approval for the appointment of directors and chief executives, and for controllers.

5. Liquidity Ratio The Banking Ordinance requires all authorized institutions in Hong Kong to maintain a Liquidity Ratio of not less than 25% in each calendar month. The ratio is expressed in percentage of the net weighted amount of an authorized institution’s liquefiable assets to its qualifying liabilities for each calendar month, based on the sum of net weighted amount of the liquefiable assets and the sum of the qualifying liabilities for each working day of that month.

6. Liquidity Ratio Banking Ordinance 1986 : Every authorized institution in Hong Kong should maintain a liquidity ratio of not less than 25% in each calendar month. Sum of its liquefiable assets Sum of its qualifying liabilities for each working day of the calendar month

7. Liquefiable Assets Authorized institutions should maintain a liquidity ratio of not less than 25% in each calendar month. In particular, the liquefiable assets of an authorized institution (with liquidity conversion factors specified in percentage) include :

8. Liquefiable Assets 1. Currency notes and coins100% 2. Gold100% 3. The amount by which the total one-month liabilities of the authorized institution to relevant banks are exceeded by the total one-month liabilities of relevant banks to it100% 4. Export bills : (a) payable within 1 month drawn under letters of credit issued by, or accepted and payable by relevant banks100% (b) covered by irrevocable re-discounting facilities approved by the HKMA100%

9. Liquefiable Assets 5. Marketable debt securities or prescribed instruments : issued or guaranteed by – (i) the Hong Kong Government, the Exchange Fund, a public sector entity in Hong Kong or multilateral development bank, with a remaining term to maturity of – (A) not more than 1 year100% (B) more than 1 year 95% (ii) an AI incorporated in Hong Kong or the Hong Kong branch of an AI incorporated overseas with a remaining term of maturity of – (A) not more than 1 month 100% (B) more than 1 month but not more than 1 year 95% (C) more than 1 year 90%

10. Liquefiable Assets (b) with a qualifying credit rating, issued or guaranteed by - (i) the central bank or central government of any country with a remaining term of maturity of – (A) not more than 1 year100% (B) more than 1 year 95% (ii) a relevant bank, other than one referred to in item 5(a)(ii), with a remaining term to maturity of – (A) not more than 1 month 100% (B) more than 1 month but not more than 1 year 95% (C) more than 1 year 90%

11. Liquefiable Assets  (iii) a regional government of any country or other institution with a remaining term to maturity of –  (A) not more than 1 year 90%  (B) more than 1 year but not more than 5 years 85%  (C) more than 5 years 80%

12. Liquefiable Assets (c) without a qualifying credit rating issued or guaranteed by a relevant bank, other than one referred to in item 5(a)(ii), with a remaining term to maturity of not more than 1 month 100% (d) approved for inclusion by the HKMA 80% (e) not included elsewhere in this item with a remaining term to maturity of not more than 1 month 80% 6. Eligible loan repayments 80%

13. Qualifying Liabilities  Total 1-month liabilities to relevant banks – Total 1-month liabilities owed by relevant banks +  Total of other liabilities due within 1 month

14. Liquidity Assessment Besides using liquidity ratio to supervise the liquidity adequacy of a bank, the Hong Kong Monetary also adopts a more comprehensive approach in assessing the adequacy of a financial institution’s liquidity. This approach includes the following quantitative or qualitative factors :

15. Liquidity Assessment (i) maturity mismatch profile; (ii) ability to borrow in the interbank market; (iii) loan-to-deposit ratio; (iv) diversity and stability of deposit base; and (v) size of intra-group transactions.

16. Liquidity Management It is vitally important for banks to maintain sufficient cash and liquid assets which can be used to repay depositors and to meet the loan requirements. However, the more cash and liquid assets which can be quickly turned into cash that a bank holds, the less interest it earns. Because the most illiquid assets, i.e. long-term loans and advances to customers, earn the highest rates of interest for a bank.

17. Capital Adequacy Ratio The Capital Adequacy Ratio first came into effect in the Banking Ordinance 1986 which required every authorized institution in Hong Kong to maintain a capital adequacy ratio of not less than 5%.

18. Capital Adequacy Ratio In 1987, the Committee on Banking Regulations of the Bank for International Settlements (now called the Basle Committee) suggested that the minimum Capital Adequacy Ratio for banks should not be less than 8% by the end of 1992.

19. Capital Adequacy Ratio Although Hong Kong was not a member of the Basle Committee, the Banking Commissioner of Hong Kong, after consultation, decided to follow the Basle Committee’s decision and raise the Capital Adequacy Ratio to not less than 8% from the end of 1989.

20. Capital Adequacy Ratio Every authorized institution in Hong Kong should maintain a Capital Adequacy Ratio of not less than 8%

21. Capital Adequacy Ratio The ratio is calculated as the percentage of an authorized institution’s capital base to its risk-weighted exposure. The capital base is the sum in Hong Kong dollars of the book value of the Core capital and the Supplementary capital.

22. Capital Adequacy Ratio The banks are required to have capital equal in value to at least 8% of the total risk- weighted assets. Within this ratio of 8%, at least half of the capital base should be in Tier 1 assets.

23. Core capital  Paid-up ordinary share capital  Paid-up irredeemable non-cumulative preference share capital  Share premium account balance  Profit and loss account balance

24. Supplementary capital  Inner reserves  Reserves on revaluation of its property  Latent reserves (the difference between the market value and book value of securities listed on the Stock Exchange)  General provisions against doubtful debts

25. Risk-weighted exposure of on-balance-sheet items Category I – Cash ItemsRisk weight 1. Notes and coins 0% 2. Hong Kong Government certificates of indebtedness 0% 3. Gold bullion in the possession of an authorized institution or held on an allocated basis, to the extent backed by gold liabilities 0% 4. Gold held which is not backed by gold liabilities 100%

26. Risk-weighted exposure of on-balance-sheet items 5. Claims to the extent that they are collateralized by cash deposits held by the authorized institution 0% 6. Cash items in the course of collection 20% 6A. Amounts due from the sale of securities, where the authorized institution has executed the transaction on behalf of a customer or for its own accounts, up to and including the fifth working day after the due settlement date in respect of the transaction 0%

27. Risk-weighted exposure of on-balance-sheet items 6B. Amounts due from the purchase of securities, where the authorized institution has executed the transaction on behalf of a customer, up to and including the fifth working day after the due settlement date in respect of the transaction 0%

28. Tier 1 and Tier 2 Countries Tier 1 countries are any countries of the Organization for Economic Co- operation and Development (OECD) or any countries which have a special lending arrangement with the International Monetary Fund (IMF) Tier 2 countries are any countries not in Tier 1

29. Risk-weighted exposure of on-balance-sheet items Category II – Claims on Central Governments and Central Banks 7. Loans to, or loans to the extent that they are guaranteed by, the Exchange Fund 0% 8. Loans to, or loans to the extent that they are guaranteed by, the central government or the central bank of any Tier 1 country 0%

30. Risk-weighted exposure of on-balance-sheet items 9. Holdings of fixed interest securities with a residual maturity of under 1 year or floating rate securities of any maturity issued by or guaranteed by the central government or by the central bank of a Tier 1 country, or by the Exchange Fund, or claims to the extent that they are collateralized by such securities 10%

31. Risk-weighted exposure of on-balance-sheet items 10. Holdings of fixed interest securities with a residual maturity of 1 year and over issued by or guaranteed by the central government or by the central bank of a Tier 1 country, or by the Exchange Fund, or claims to the extent that they are collateralized by such securities 20% 11. Loans denominated in the currency of a Tier 2 country and funded in that currency, to, or to the extent that are guaranteed by the central government or the central bank of that country 0%

32. Risk-weighted exposure of on-balance-sheet items 12. Holdings of fixed interest securities with a residual maturity of under 1 year or floating rate securities of any maturity issued by or guaranteed by the central government or by the central bank of a Tier 2 country, where denominated and funded in the currency of that country10%

33. Risk-weighted exposure of on-balance-sheet items 13. Holdings of fixed interest securities with a residual maturity of 1 year and over issued by or guaranteed by the central government or by the central bank of a Tier 2 country, here denominated and funded in the currency of that country 20% 14. Other claims on the central government or on the central bank of a Tier 2 country 100%

34. Risk-weighted exposure of on-balance-sheet items Category III – Claims on Public Sector Entities 15. Claims on or to the extent that they are guaranteed by or to the extent that they are collateralized by securities issued by public sector entities in Hong Kong 20% 16. Claims on or to the extent that they are guaranteed by or to the extent that they are collateralized by securities issued by public sector entities of any other Tier 1 country 20%

35. Risk-weighted exposure of on-balance-sheet items 17. Claims on public sector entities of a Tier 2 country 100% Category IV – Claims on Banks 18. Claims on or to the extent that they are guaranteed by authorized institutions or banks incorporated in Tier 1 countries 20% 19. Claims on or to the extent that they are guaranteed or collateralized by securities issued by a multilateral development bank 20%

36. Risk-weighted exposure of on-balance-sheet items 20. Claims on or to the extent that they are guaranteed by any bank other than a bank referred to in item 18 or 19, with a residual maturity of under 1 year 20% 21. Claims on or to the extent that they are guaranteed by any bank other than a bank referred to in item 18 or 19, with a residual maturity of 1 year or more 100%

37. Risk-weighted exposure of on-balance-sheet items Category V – Residential Mortgages 22. Loans fully secured by a residential mortgage 50% 23. Securities backed by residential mortgages and participations in residential mortgages, provided the holders of such securities will not absorb more than their pro rata share of losses in the event of arrears or default on payment of interest on, or principal of, the underlying mortgage loans 50%

38. Risk-weighted exposure of on-balance-sheet items Category VI – Other Assets 24. Claims on non-bank private sector persons100% 25. Investments in the equity or other capital instruments of other banks other than where deducted from the capital base100% 26. Premises, plant and equipment and other fixed assets for the authorized institution’s own use 100% 27. Other interests in land 100% 28. All assets not elsewhere specified 100%

39. Risk-weighted exposure of off-balance-sheet items The off-balance sheet items will first be converted to their credit equivalent amounts by respective credit conversion factors, and the appropriate risk weights will then be applied to arrive at the risk weighted amount. Risk weights are applied according to the type of counterparties as for on-balance sheet items.

40. Risk-weighted exposure of off-balance-sheet items Off-balance ItemsConversion Factors 1. Direct credit substitutes100% 2. Transaction-related contingencies 50% 3. Trade-related contingencies 20% 4. Sale and repurchase agreements100% 5. Assets sales or other transactions with recourse100%

41. Risk-weighted exposure of off-balance-sheet items 6. Forward asset purchases100% 7. Partly paid-up shares and securities (held by the authorized institution)100% 8. Forward deposits placed100% 9. Note issuance and revolving underwriting facilities 50% 10. Other commitments with an original maturity of under 1 year, or which may be cancelled unconditionally by the authorized institution 0%

42. Risk-weighted exposure of off-balance-sheet items 11. Other commitments with an original maturity of 1 year or over 50% 12. Exchange rate and gold contracts (a) credit conversion factors to be used in calculating in accordance with original exposure method – contracts with an original maturity of – (i) 1 year or less 2% (ii) over 1 year to 2 years 5% (iii) over 2 years, the factor for over 1 year to 2 years plus for additional year 3%

43. Risk-weighted exposure of off-balance-sheet items (b) credit conversion factors to be used to determine the potential future credit exposure in accordance with the current exposure method – contracts with a residual maturity of – (i) 1 year or less 1% (ii) over 1 year to 5 years 5% (iii) over 5 years 7.5%

44. Risk-weighted exposure of off-balance-sheet items 13. Interest rate contracts (Calculated in accordance with either the original exposure method or the current exposure method) (a) credit conversion factors to be used in calculating in accordance with the original exposure method – contracts with an original maturity of – (i) 1 year or less 0.5% (ii) over 1 year to 2 years 1% (iii) over 2 years, the factor for over 1 year to 2 years plus for each additional year 1%

45. Risk-weighted exposure of off-balance-sheet items (b) credit conversion factors to be used to determine the potential future credit exposure in accordance with the current exposure method – contracts with a residual maturity of – (i) 1 year or less 0% (ii) over 1 year to 5 years 0.5% (iii) over 5 years 1.5%

46. Risk-weighted exposure of off-balance-sheet items 14. Equity contracts (Calculated in accordance with the current exposure method) – credit conversion factors to be used to determine the potential future credit exposure in accordance with the current exposure method – contracts with a residual maturity of – (a) 1 year or less 6% (b) over 1 year to 5 years 8% (c) over 5 years 10%

47. Risk-weighted exposure of off-balance-sheet items 15. Precious metals other gold contracts (Calculated in accordance with the current exposure method) – credit conversion factors to be used to determine the potential future credit exposure in accordance with the current exposure method – contracts with a residual maturity of – (a) 1 year or less 7% (b) over 1 year to 5 years 7% (c) over 5 years 8%

48. Risk-weighted exposure of off-balance-sheet items 16. Commodities other than precious metals and gold contracts (Calculated in accordance with the current exposure method) – credit conversion factors to be used to determine the potential future credit exposure in accordance with the current exposure method – contracts with a residual maturity of – (a) 1 year or less 10% (b) over 1 year to 5 years 12% (c) over 5 years 15%

49. Capital Adequacy Ratio Authorized institutions incorporated overseas are subject to the Capital Adequacy Ratio requirement of their country of incorporation. Each authorized institution incorporated in Hong Kong is required to maintain at all times a Capital Adequacy Ratio of at least 8%. The HKMA may raise the ratio for a particular institution to 12% in the case of a licensed bank and 16% in the case of a restricted licence bank or deposit-taking company.

50. Capital Adequacy Ratio The following table is an example of Capital Adequacy Ratio calculation, in the balance sheet of a Hong Kong incorporated authorized institution XYZ Bank according to the Banking Ordinance : At least half the capital base (i.e. HK$30.1 million) must be in Tier 1 assets.

51. Liquidity versus Capital Adequacy Liquidity is concerned with a bank’s ability to meet all its obligations in the short term while capital adequacy is concerned with a bank’s ability to absorb any losses which may be incurred.

52. Market Risk Report In 1996, the Hong Kong Monetary Authority introduced a quarterly return on market risk exposures which required locally incorporated authorized institutions to measure and apply capital charges in respect of their market risks in addition to their credit risks under the Capital Adequacy Ratio.

53. Market Risk Report The objective is to ensure that institutions are maintaining adequate capital to support the potential loss arising from fluctuations in market prices to which they are exposed, particularly those arising from their trading activities.

54. Market Risk Report Foreign banks operating through branches in Hong Kong are not subject to the requirement because the primary responsibility for supervising capital adequacy of these institutions rests with the home supervisor.

55. Market Risk Report The new return aims to measure the risks pertaining to interest rate related instruments and equities in the trading book; and foreign exchange risk and commodities risk throughout the institution. The market risk measurement system closely follows the Basle Committee’s market risk measurement framework.

56. Market Risk Report Capital would be considered to be “adequate” if the adjusted capital adequacy ratio (i.e. after adjusting for market risk exposure) is above the statutory minimum capital adequacy ratio which has already been set for the authorized institution in question.