B4 Capital strength and capability to withstand risk (including CAAP)

B4.1 Review of CAAP

 The MA assesses the CAAP of AIs that are subject to the CAAP standards set out by him against those standards.

Among other things, the MA will:

- assess the degree to which the AI’s CAAP and internal capital targets have incorporated the full range of material risks faced by it;

- review the adequacy of risk measures used in assessing internal capital adequacy and the extent to which these risk measures are used operationally in setting limits, evaluating business line performance, and evaluating and controlling risks more generally;

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- consider, in particular, whether the AI’s remuneration and valuation practices have any adverse effects on its capital adequacy²⁷;

- determine whether capital targets are comprehensive and relevant to the current operating environment, and are properly monitored and reviewed by senior management;

- determine whether the composition of capital is appropriate for the nature and scale of the AI’s business;

and

- consider the extent to which the AI has provided for unexpected events in setting its capital levels, whether the analysis covers a wide range of external factors, conditions and scenarios, and whether the stress-testing techniques and scenarios used are commensurate with the AI’s activities.

 For AIs that are not subject to the CAAP standards, the MA assesses their capital planning and management processes, taking into account their business size and complexity.

B4.2 Review of capital strength and capability to withstand risk

 An overall assessment of capital adequacy should take into account all factors that affect an AI’s financial condition.

Therefore, apart from those mentioned in subsection B4.1 above, the MA will consider the following factors:

Capital structure, level and trends

- The MA compares the level and trend of an AI’s actual CAR with the §97F minimum CAR assigned to the AI (also taking into account the AI’s BCR buffer level or

27 For example, remuneration policies that encourage excessive short-term profit-taking may pose longer-term risks to the AI, whilst the lack of robust valuation methodologies and procedures may understate the potential risks arising from illiquid positions.

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§97F buffer level, whichever applicable) and with the average levels of CAR maintained by its peers to determine if its CAR has been kept at prudent levels. In addition, the projected asset growth and earnings performance should reasonably support an AI’s ability to maintain its capital levels without undue reliance on capital injections. For a newly authorized AI, the level of its CAR should be reasonable in relation to its business plans and competitive environment.

- The MA also reviews the quality of an AI’s capital by analysing the composition of its capital base (e.g. the level of CET1 / Tier 1 capital in relation to total capital base).

Strategic planning

 The MA assesses whether an AI’s capital planning is supported by an effective strategic plan which should clearly outline the AI’s capital needs, anticipated capital expenditures, desirable capital level, and external capital sources. The Board and senior management should regard capital planning as a crucial element for achieving the desired strategic objectives, and should effectively communicate the AI’s corporate goals and objectives throughout the organisation.

Business expansion

 The MA assesses whether an AI has adequate capital resources to support its business growth. The MA will pay particular attention to situations where rapid lending growth may become a cause for concern if this is achieved by reducing the AI’s underwriting standards and increasing its risk profile.

Dividends

 Excessive cash dividend payments may weaken an AI’s capital adequacy. The MA reviews an AI’s dividend policy as well as its historical and planned cash dividend

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payout ratios to determine whether dividend payments are impairing capital adequacy.

Access to additional capital

 AIs that do not generate sufficient capital internally may require external sources of capital. Large, independent AIs may solicit additional funding from the capital markets to support their business growth or acquisition plans. Smaller AIs may rely solely on their parent banks or major shareholders to provide additional funds, or on the issue of new capital instruments to existing or new investors.

 The MA assesses an AI’s ability to obtain additional funding from the capital markets in times of need, taking into account the potential difficulties in raising additional capital during downturns or other times of stress, and the strength and availability of its parental support in the provision of new capital. If the AI has subsidiaries and affiliates, the MA will review its commitment and responsibility to provide capital to these subsidiaries and affiliates.

 The MA also expects an AI to have a plan that enables it to operate effectively throughout a severe and prolonged period of financial market stress or an adverse credit cycle, as well as contingency plans that address unexpected capital or liquidity needs during crisis situations.

Asset quality and provisions

 The MA takes into account the potential impact of an AI’s asset quality, particularly the severity of its problem and classified assets and the adequacy of its bad debt provisions, on its capital adequacy.

Earnings

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 The MA assesses an AI’s earning ability to ascertain the stability of its capital. Poor earnings or losses can adversely affect an AI’s capital adequacy by preventing the AI from replenishing its capital internally in the case of poor earnings or by depleting its CET1 capital in the case of losses.

Off-balance sheet items

 Once funded, off-balance sheet items become subject to the same capital requirements as on-balance sheet items. The MA reviews an AI’s off-balance sheet activities (including securitization transactions) to assess whether its capital levels are sufficient to support the on-balance sheet assets that would result from a significant portion of the off-balance sheet items being funded within a short time, and to evaluate the possibility of the AI having to bring a portion of securitized assets (e.g. in respect of the AI’s sponsored securitization structures) onto its balance sheet and the likely impact of this on its capital and financial positions (see Annex E for more details).

Market value of an AI’s stock

 For a listed AI, its stock price is reflective of investors’

confidence in, and support for, the AI, the lack of which could impair the AI’s ability to raise additional capital. If an AI’s stock is trading at low prices, it may indicate investors’ lack of confidence in the AI, or that there are other problems besetting the AI. The MA reviews whether the stock of the AI or, where applicable, its listed parent bank or holding company has been trading at reasonable prices (e.g. in terms of a reasonable multiple of its earnings or a reasonable percentage (or multiple) of its book value) in order to identify whether there are any concerns that warrant his attention.

Capital instruments with redemption features

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- The MA assesses the potential performance of an AI’s capital instruments during times of stress and the ability of the instruments to absorb the AI’s losses and support its ongoing business operations.

- The MA will pay particular attention to the impact of redemption (including early redemption) of capital instruments with redemption features on an AI’s overall capital structure. The AI should thoroughly assess such impact if the redemption could have a material effect on the level or composition of its capital base. If an AI plans to redeem a capital instrument with the proceeds of, or replace it by, a like amount of a similar capital instrument, the AI should consider the likelihood that it will actually be able to do so within the time planned.

- In reviewing an AI’s funding and financial condition, the MA also takes into account the potential impact of redemption of capital instruments that are not eligible for inclusion in the calculation of the AI’s §97F minimum investment securities or bank premises may represent capital to the AI.

- The Banking (Capital) Rules allow certain amounts of unrealized gains on asset values to be included in the calculation of the regulatory capital base. In some cases, such as for example unrealized gains on real property revaluation, the amount which can be included is subject to restriction, which effectively results in a certain amount of unrealized gain being “disallowed”

from inclusion. In the SRP review of an AI’s overall capital adequacy, the MA however takes these asset values into account, considering in particular the nature

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of the assets, the reasonableness of their valuation, their marketability, and the likelihood of their sale. Whilst adopting this broader view, the MA is nevertheless concerned to identify cases where there appears to be undue reliance on unrealised gains to satisfy actual and projected capital requirements. Even though Basel III allows unrealised gains on securities to be recognized in the regulatory capital base, the MA will expect AIs not to place undue reliance on unrealised gains in constituting their CET1 capital.

 In assessing an AI’s capability to withstand risk, the MA conducts sector-wide stress tests to assess individual AIs’

vulnerability to severe market shocks or crisis situations (e.g. based on hypothetical scenarios that are similar to, or more severe than, those experienced during the 1997/1998 Asian Crisis or the 2007/2008 Global Financial Crisis). The MA also considers whether “outlier” AIs that show significant vulnerability to “stressed” situations, compared with their peers, warrant a higher §97F minimum CAR, §97F buffer level and/or a reduction in risk exposures.