Supervisory Policy Manual CA-G-1 Overview of Capital Adequacy V.3 – 19.06.20 Regime for Locally Incorporated Authorized Institutions This module should be read in conjunction with the Introduction and with the Glossary, which contains an explanation of abbreviations and other terms used in this Manual. If reading on-line, click on blue underlined headings to activate hyperlinks to the relevant module. ————————— Purpose To set out the HKMA’s policy on capital adequacy for AIs incorporated in Hong Kong and to provide an overview of the framework for the calculation of such AIs’ capital adequacy ratio. Classification A statutory guideline issued by the MA under the Banking Ordinance (the Ordinance), §7(3). Previous guideline(s) superseded CA-G-1 “Overview of Capital Adequacy Regime for Locally Incorporated Authorized Institutions” (V.2) dated 27.02.15 Application To all locally incorporated AIs Structure 1. Introduction 1.1 Terminology 1.2 Background 2. Approach to supervising AIs’ capital adequacy 3. Solo CAR and LR requirements 4. Consolidated CAR and LR requirements 5. Calculation of CAR 1 Supervisory Policy Manual CA-G-1 Overview of Capital Adequacy V.3 – 19.06.20 Regime for Locally Incorporated Authorized Institutions 6. Composition of capital base 6.1 General 6.2 Tier 1 capital 6.3 Tier 2 capital 6.4 Self-assessment of capital instruments 6.5 Point of non-viability 6.6 Regulatory deductions 7. Capital buffers 8. Risk-weighting framework 8.1 Risk coverage 8.2 Credit risk (non-securitization exposures) 8.3 Exposures to central counterparties 8.4 Credit risk (securitization exposures) 8.5 Use of credit risk mitigation techniques 8.6 Market risk 8.7 Operational risk 8.8 Sovereign concentration risk 9. Calculation of leverage ratio 10. Assessment of overall capital adequacy 11. Interest rate risk in the banking book 12. Determination of minimum CAR requirements 13. Monitoring compliance with minimum CAR requirements 14. Consequences of contraventions 15. Financial disclosures 16. Further developments ————————— 2 Supervisory Policy Manual CA-G-1 Overview of Capital Adequacy V.3 – 19.06.20 Regime for Locally Incorporated Authorized Institutions 1. Introduction 1.1 Terminology 1.1.1 Unless otherwise specified, abbreviations and terms used in this module have the same meaning as those used in the Banking (Capital) Rules (BCR). 1.2 Background 1.2.1 Capital is important to a bank as, apart from being a permanent source of funding for business operations and growth, it provides a buffer to absorb losses. In so doing, capital not only reduces the risk of insolvency of a bank but can also enable the bank to continue to conduct its credit intermediation activities in times of stress, thereby reducing any propensity for the banking sector to amplify the effects of a financial and economic downturn. The prudential regulation of banks therefore seeks to ensure that banks hold sufficient capital (and reserves) against the inherent risks in their business. 1.2.2 The HKMA’s policy on capital adequacy closely reflects the latest regulatory capital standards published by the Basel Committee on Banking Supervision (BCBS). As from 1 January 2013, the HKMA commenced implementation of the Basel III capital standards in Hong Kong in accordance with the transitional arrangements1 specified by the BCBS. Sections 2 to 15 of this module present an overview of the capital standards under Basel III that are currently effective in Hong Kong. Section 16 of this module briefly outlines the key capital standards that are to be implemented in 1 The transitional arrangements provide for the phase-in of the various components of Basel III from 1 January 2013 to 1 January 2019 to help ensure that the banking sector can meet the higher capital standards under Basel III, while still supporting lending to the economy. Most of the transitional arrangements provided to AIs already ended on 1 January 2019, except the phasing out of eligible Basel II capital instruments that will continue until 31 December 2021. 3 Supervisory Policy Manual CA-G-1 Overview of Capital Adequacy V.3 – 19.06.20 Regime for Locally Incorporated Authorized Institutions the near future. 2. Approach to supervising AIs’ capital adequacy 2.1 The HKMA’s regulatory framework for the capital adequacy of AIs incorporated in Hong Kong consists of the following elements: 2.1.1 As one of the minimum criteria for authorization set out in the Seventh Schedule to the Ordinance, the MA needs to be satisfied that an institution applying for authorization presently has, and will if it is authorized continue to have, financial resources (whether actual or contingent) which are adequate for the nature and scale of its operations (see the first part of paragraph 6 of the Seventh Schedule to the Ordinance). In the case of locally incorporated AIs, this criterion will mainly be satisfied by the institutions complying with the BCR made pursuant to the Ordinance (including the minimum capital adequacy ratio (CAR) set out in §3B of the BCR as may be varied under §97F of the Ordinance (see paragraph 2.1.3 below) and the minimum leverage ratio (LR) set out in §3Z of the BCR (see paragraph 2.1.4 below)). For an AI that is subject to loss absorbing capacity requirements under the Financial Institutions (Resolution) (Loss-absorbing Capacity Requirements – Banking Sector) Rules (LAC Rules), the MA will, in making an assessment of the financial resources of the AI, also have regard to whether the AI complies and will continue to comply with the LAC Rules. 2.1.2 The CAR as defined in §3 of the BCR is a collective term referring to the three risk-weighted capital ratios, namely the: (a) Common Equity Tier 1 (CET1) capital ratio; (b) Tier 1 capital ratio; and (c) Total capital ratio, 4 Supervisory Policy Manual CA-G-1 Overview of Capital Adequacy V.3 – 19.06.20 Regime for Locally Incorporated Authorized Institutions prescribed under Basel III. The minimum CAR, in terms of the three ratios as prescribed in §3B of the BCR, is 4.5%, 6% and 8% respectively. 2.1.3 To enable the MA to take account of the risks associated with a particular AI, §97F(1) of the Ordinance empowers the MA to vary any capital requirement rule (including the minimum CAR applicable to the AI under §3B of the BCR) if he is satisfied, on reasonable grounds, that it is prudent to make the variation, taking into account the risks associated with the AI. If the MA proposes to vary any capital requirement rule (including the minimum CAR) applicable to an AI, the AI will be given an opportunity to make representations as provided for under §97F(3)(b) of the Ordinance. In addition, an AI aggrieved by a decision of the MA under §97F(1) of the Ordinance may apply to the Banking Review Tribunal (BRT) under §101B(1) of the Ordinance for a review of that decision. 2.1.4 The LR, as defined in §3Y of the BCR, is a non-risk based measure of an AI’s capital adequacy introduced under Basel III as a “back-stop” to restrict the build-up of excessive leverage in the banking sector and to provide an additional safeguard against model risk and measurement error in the risk-based CAR calculation. The minimum LR, as prescribed in §3Z of the BCR, is 3%. 2.1.5 Under paragraph 2 of the Eighth Schedule to the Ordinance, the failure of an AI to meet the criteria set out in paragraph 6 of the Seventh Schedule to the Ordinance would provide grounds for the MA to revoke the AI’s authorization. An AI’s breach of the BCR will not, however, automatically lead to the revocation of its banking licence, and the MA will discuss remedial action with the AI (as required under §97E(1) of the Ordinance) and will likely require the AI to submit a remediation plan. If the plan meets with the MA’s 5 Supervisory Policy Manual CA-G-1 Overview of Capital Adequacy V.3 – 19.06.20 Regime for Locally Incorporated Authorized Institutions approval and seems reasonable and practically achievable, the MA may then serve a written notice on the AI under §97E(2) of the Ordinance requiring the AI to implement the remediation plan. Under §97E(4) of the Ordinance, if an AI fails to comply with any requirement imposed in a notice served on it under §97E(2) of the Ordinance, then every director, every chief executive and every manager of that AI commits an offence (see section 14 of this module for details). 2.1.6 Under §97D(3) of the Ordinance, if an AI fails to immediately notify the MA regarding a matter prescribed in the BCR2, then every director, every chief executive and every manager of that AI commits an offence. 2.1.7 In broad terms, the BCR impose CAR requirements on an AI at two levels (and likewise for LR requirements): (a) on a solo basis, which measures the capital adequacy of an AI based on the capital strength, risk profile, or the on- and off-balance sheet exposures of the AI taking into account the combined position of its head office and branches, both in and outside Hong Kong; (b) on a consolidated basis, which measures the capital adequacy of an AI based on the capital strength, risk profile, or the on- and off-balance sheet exposures of the AI after consolidating the assets and liabilities of such of its subsidiaries as specified by the MA for such calculation purposes. 2.1.8 AIs are required to calculate their CAR in accordance with the methodologies and requirements set out in the BCR. The BCR set out various alternative 2 Such as: (i) §3D of the BCR, which requires an AI to immediately notify the MA of its failure to comply with any of the minimum CAR set out in §3B of the BCR, as the same may be varied by the MA under §97F(1) of the Ordinance; and (ii) §3ZA of the BCR, which requires an AI to immediately notify the MA of its failure to comply with the minimum LR set out in §3Z of the BCR. 6 Supervisory Policy Manual CA-G-1 Overview of Capital Adequacy V.3 – 19.06.20 Regime for Locally Incorporated Authorized Institutions approaches which AIs can use to calculate their capital requirements for credit risk, market risk and operational risk. Certain of these approaches, however, can only be adopted by an AI if the AI satisfies specified criteria and has obtained the prior approval of the MA (see section 8 of this module for details). The approval may be granted subject to any conditions that the MA thinks proper to attach to the approval in any particular case. If an AI disagrees with a decision made by the MA in respect of the AI’s application to use a particular approach (including a decision to attach conditions to the approval of the application granted by the MA), the AI may under §101B(1) of the Ordinance apply to the BRT for a review of that decision. For the calculation of their LR, AIs are required to apply the formula likewise specified in the BCR (see section 9 of this module for details). 2.1.9 To ensure that AIs have adequate capital to guard against their exposure to all risks (i.e. not only those captured in the CAR calculation under the BCR which focuses on the Basel “Pillar 1” risks – i.e. credit risk, market risk and operational risk), the HKMA adopts a risk-based and structured framework to set and review individual AIs’ minimum CAR requirements. This framework, which reflects Pillar 2 of the Basel regulatory capital framework and is referred to as the supervisory review process (SRP), is set out in CA-G- 5 “Supervisory Review Process”. 2.1.10 AIs should have an internal capital adequacy assessment process (CAAP) for assessing their overall capital adequacy in relation to their risk profile. They should also have a strategy for maintaining the required level of capital. The supervisory standards expected of AIs’ CAAP are set out in CA-G-5. The HKMA evaluates an AI’s CAAP and capital adequacy through the SRP and uses the results for determining the AI’s minimum CAR requirements which are commensurate with its risk profile. The MA may issue 7 Supervisory Policy Manual CA-G-1 Overview of Capital Adequacy V.3 – 19.06.20 Regime for Locally Incorporated Authorized Institutions a notice under §97F of the Ordinance to vary the minimum CAR applicable to the AI if the MA is satisfied on reasonable grounds that it is prudent to do so, taking into account the risks associated with the AI. 2.1.11 Furthermore, it has been the HKMA’s practice to require AIs to set non-statutory internal capital targets above the statutory minimum requirements and any applicable regulatory capital buffers (and likewise for LR, a non-statutory internal LR target above their minimum LR requirement), which serve as an early warning signal for potential contravention of the statutory requirements (see paragraphs 9.5 and 13.1 below for more details). 2.1.12 As set out in the Banking (Disclosure) Rules (BDR) made by the MA under §60A of the Ordinance, AIs (unless they are exempted by the MA under the BDR) are required to disclose publicly information in relation to their state of affairs, including their profit and loss and their financial resources (including capital resources and liquidity resources) in accordance with the standards set out in the BDR and by reference to CA-D-1 “Guideline on the Application of the Banking (Disclosure) Rules”. 2.2 Where necessary, further elaboration on the capital adequacy framework is (and will continue to be) provided in supplementary guidance issued by the HKMA from time to time in the form of codes of practice, guidelines, circular letters, supervisor’s memos, Frequently Asked Questions, etc. 2.3 It should however be borne in mind that the CAR of an AI only provides a snap-shot indication of the AI’s capital position. The minimum CAR requirements, though an important element in the HKMA’s regulatory regime, are not (and never have been) substitutes for a sound risk management and control environment 8 Supervisory Policy Manual CA-G-1 Overview of Capital Adequacy V.3 – 19.06.20 Regime for Locally Incorporated Authorized Institutions which all AIs should have in place and which is the most effective way to mitigate risks. 3. Solo CAR and LR requirements 3.1 In order to provide a conservative measure of each AI’s stand- alone capital strength, all AIs are required to comply with the minimum CAR and LR requirements on a solo basis. To arrive at the capital position of an AI on a solo basis, the investments of the AI in capital instruments issued by, or non-capital LAC liabilities3 of “financial sector entities” (as defined in the BCR) are subject to the deduction requirements under the BCR. These entities include: (a) those that are members of the AI’s consolidation group; and (b) those that are not members of the AI’s consolidation group, in which case exemptions are allowed for: (i) “insignificant LAC investments”4 in the form of CET1 capital instruments, Additional Tier 1 capital instruments and Tier 2 capital instruments, or non-capital LAC liabilities (provided the amounts are within the specified “thresholds”, determined by reference to 5% and 10% of the CET1 capital of the AI) calculated in accordance with Schedule 4F to the BCR; and (ii) “significant LAC investments”5 in the form of CET1 capital instruments (up to 10% of the CET1 capital of the AI) calculated in accordance with Schedule 4G to the BCR. Investments in capital instruments and non-capital LAC liabilities that are not deducted from the AI’s capital base 3 Please refer to rule 2(1) of the LAC Rules for the definition of “non-capital LAC liabilities”. 4 An “insignificant LAC investment”, as defined in §35 of the BCR, refers to an investment by an AI in a capital instrument issued by, or a non-capital LAC liability of, an entity that is not an affiliate of the AI and of which the AI owns not more than 10% of the issued ordinary share capital. 5 A “significant LAC investment”, as defined in §35 of the BCR, refers to an investment by an AI in a capital instrument issued by, or a non-capital LAC liability of: (i) an affiliate of the AI; or (ii) any other entity of which the AI owns more than 10% of the issued ordinary share capital. 9 Supervisory Policy Manual CA-G-1 Overview of Capital Adequacy V.3 – 19.06.20 Regime for Locally Incorporated Authorized Institutions must however still be subject to risk-weighting treatment as required under the BCR. 3.2 An AI may, however, apply to the MA under §28(1) of the BCR for approval to include any subsidiary in the calculation of its solo CAR and LR6 (referred to in the BCR as a “solo-consolidated” basis for the calculation of CAR and LR). Before approving such application, the MA must be satisfied that the subsidiary concerned meets the following criteria: (a) the subsidiary is wholly owned by, and managed as if it were an integral part of, the AI; (b) the subsidiary is wholly financed by the AI such that the subsidiary has no depositors or other external creditors except external creditors for audit fees, company secretarial services and sundry operating expenses; and (c) there are no regulatory, legal or taxation constraints on the transfer of the subsidiary’s capital to the AI. 4. Consolidated CAR and LR requirements 4.1 Where an AI undertakes other banking and financial business through subsidiary companies, it is normally expected to provide the necessary capital to support the latter’s operations. To ensure that the AI’s capital position is maintained at an adequate level taking into account its exposures to risks stemming from such subsidiaries, the MA will generally require the AI to comply with its minimum CAR and LR requirements on a consolidated basis, in addition to a solo / solo-consolidated basis, by issuing a notice under §3C(1) of the BCR to the AI. 4.2 When calculating its CAR and LR on a consolidated basis, an AI is only required to include those subsidiaries which the MA has specified in the notice issued under §3C(1) of the BCR. The MA will generally only specify those subsidiaries engaging mainly in 6 Under §3Z(2) of the BCR, LR must be calculated on the same basis as that adopted for the calculation of CAR under Division 7 of Part 2 to the BCR. 10