109. Section 101 of the Banking Ordinance provides for the HKMA, after consultation, to vary an AI’s capital adequacy ratio by increasing it to not more than 16%. With the minimum Pillar 1 requirement set at 8%, this effectively means that the maximum size of the Pillar 2 add-on for locally incorporated AIs is 8%. The Banking (Amendment) Bill 2011, which was introduced into the Legislative Council in December 2011, provides for the HKMA to set and vary capital requirements for locally incorporated AIs26. No upper limit for variation is specified. This point was discussed in the papers sent to the industry associations on 13 October 2011 concerning “Basel III implementation – Consultation on proposed amendments to the Banking Ordinance” (see paragraph 3.11 of Annex 2 to the HKMA’s letter of that date).
Broadly, the HKMA takes the view that if (i) capital is required on reasonable grounds, to maintain a capital base consistent with what is sound and prudent, taking into account the risks associated with the AI; and (ii) the HKMA must be satisfied, on reasonable grounds, that it is prudent to make a variation of an individual AI’s capital requirements; (both of these elements are specifically reflected in the Bill), there is no justification for an arbitrary limit.
Furthermore, Basel III sets no such upper limit. To alleviate to some degree any industry concerns on the removal of the upper limit, the HKMA’s power to vary capital requirements is subject to a set of checks and balances, set out in the Bill, to ensure adequate consultation and opportunity for AIs to make representations.
110. Notwithstanding the proposed removal of the 16% upper limit, the HKMA does not expect major increases in individual AIs’ Pillar 2 requirements when Basel III is implemented, provided that there are no significant changes in their overall risk profiles. Subject to the findings of the Pillar 2 review referred to in paragraph 107, the HKMA proposes to adopt, in general, the existing framework for the calibration of the Pillar 2 add-on under Basel III.
Allocation of Pillar 2 capital requirements
111. Locally incorporated AIs will be subject to three minimum risk-weighted capital ratios under Basel III, i.e. the CET1 Capital Ratio of 4.5%, the Tier 1 Capital Ratio of 6%, and a Total Capital Ratio of 8%, when all of the ratios are fully
26 The capital requirements will include the CET1 Capital, AT1 Capital and Tier 2 Capital ratios, the capital buffers and the leverage ratio.
implemented in 2015. As the Pillar 2 add-on will form part of an AI’s minimum capital requirements (see paragraph 106), a decision needs to be taken as to whether the Pillar 2 add-on should take the form of CET1 Capital only, or a mix of CET1 Capital and AT1 Capital, or a mix of all of CET1 Capital, AT1 Capital and Tier 2 Capital. The HKMA is minded to adopt a consistent basis between Pillar 1 and Pillar 2 and proposes to allocate the Pillar 2 add-on to the three capital ratios in accordance with the 4.5% / 6% / 8% split under Pillar 1.
So, for example, an AI’s minimum CET1 Capital Ratio to its minimum Total Capital Ratio (with the Pillar 2 add-on incorporated) will be 56.25% (i.e. 4.5% / 8%) and if the AI’s Pillar 2 add-on is 2%, its minimum CET1 Capital Ratio, Tier 1 Capital Ratio and Total Capital Ratio will respectively be 5.625%, 7.5% and 10%.27
112. While the above allocation method is consistent with the Pillar 1 Capital split, there is a disadvantage insofar as the approach will necessitate AIs re-calculating the Pillar 2 allocation whenever there is any change in the size of their Pillar 2 add-on, or any change in the Pillar 1 split during the phase-in period.28 AIs will also need to closely monitor, plan for and address any potential or resultant increases in capital by type (i.e. CET1 and AT1 and Tier 2 capital instruments). The HKMA would be interested to hear from the industry as to whether, from AIs’ perspective, this additional complexity outweighs the benefits of a split allocation approach and whether the simplicity offered by requiring that the Pillar 2 add-on be constituted entirely of CET1 Capital would be preferred.
113. Ideally, from a purely prudential standpoint, it would be desirable for the Pillar 2 add-on to consist largely, or wholly, of capital with the highest loss-absorbing power (i.e. common equity).29 The HKMA, however, has some residual concern that this method of allocation may create undue strain on capital-raising (taking into account the fact that the two capital buffers must also be constituted by common equity). The HKMA has therefore, on balance, opted for the proposed allocation approach outlined above, but the HKMA proposes to reserve the right to vary the allocation method for individual AIs on a case-by-case basis should supervisory concerns regarding the risk profile of a given AI so warrant.
27 5.625% = 4.5% + 1.125% (i.e. 4.5% / 8% x 2%); 7.5% = 6% + 1.5% (i.e. 6% / 8% x 2%); 10% = 8% + 2%
28 During the phase-in period, the split will be 3.5% / 4.5% / 8% for 2013 and 4% / 5.5% / 8% for 2014.
29 For example, Australia is proposing the Pillar 2 add-on to comprise only Tier 1 capital.
114. In finalising the allocation approach, the HKMA will obviously take into account comments received in this consultation and will also have regard to any prevalent approach adopted (or likely to be adopted) by other supervisors in major financial centres.
Order of application of common equity
115. The common equity held by an AI is required to meet the new minimum capital ratios and the two buffers under Basel III. The HKMA’s proposes to adopt the following order of application of the common equity held by AIs:
Order Capital requirement
1 CET1 Capital Ratio 2 Tier 1 Capital Ratio 3 Total Capital Ratio
4 Capital Conservation Buffer + Countercyclical Capital Buffer
116. This is in line with the Basel III rules which indicate that common equity must first be used to meet the minimum capital requirements before the remainder can contribute to the capital conservation buffer.30 For the purpose of applying the common equity held by an AI, the countercyclical capital buffer will be combined with the capital conservation buffer and treated as one single buffer.
Positioning of Pillar 2 within the hierarchy of the capital ladder
117. On the premise that the Pillar 2 add-on will continue to form a part of the minimum capital requirements, the HKMA proposes to adopt the following hierarchy which is also consistent with the existing Pillar 2 framework:
30 See footnote 47 of the revised Basel III capital rules text as of June 2011.
Building
Capital buffers • Capital Conservation Buffer (in common equity)
• Countercyclical Capital Buffer (in common equity) result in effective disclosure of an AI’s Pillar 2 capital requirement in the event that the AI’s capital position falls within the buffer zone (thus triggering distribution restrictions). At present an AI’s Pillar 2 add-on is not disclosed publicly. In practice the likelihood of disclosure may be less than otherwise apparent as AIs will likely manage their capital positions to internal capital targets at a level slightly above the trigger ratio.
119. The HKMA would be interested to hear from the industry whether the industry has any suggestions on how concerns on disclosure of the Pillar 2 add-on might be mitigated or whether the potential for such disclosure is indeed a significant concern.
Implementation and transitional arrangements
120. The application of the Pillar 2 approach outlined above, will come into effect from 1 January 2013 for all locally incorporated AIs. The HKMA proposes to determine the three minimum capital ratios applicable to each AI on 1 January
31 The HKMA does not envisage any significant change to the current risk-based approach to assigning a non-statutory trigger ratio to individual AIs. In practice the magnitude of the trigger ratio is at least 0.5%.
2013 by reference to the minimum CAR (and hence the Pillar 2 add-on) of the AI immediately in force before that date. This grandfathered minimum CAR (and the two other minimum capital ratios derived from it as proposed under paragraph 111) will continue in force until otherwise advised by the HKMA, as a result of the supervisory review process conducted on individual AIs after 1 January 2013 based on the prevailing Pillar 2 framework.
Further issues to be considered
121. The extent to which, if at all, the surcharge for global systemically important banks (G-SIBs) will affect the Pillar 2 framework under Basel III will be determined, taking into account the relevant assessment methodology and framework issued by the Basel Committee. Generally speaking, the surcharge for G-SIBs can be regarded as a measure to reduce the risks posed by such banks to the global financial system32 rather than the risks taken on by them, and it will form part of their capital buffers. In view of this, the HKMA considers that any overlap between the surcharge and the Pillar 2 framework is unlikely to be significant.
122. With the implementation of the Basel III liquidity standards, the liquidity risk assessment factors in the Pillar 2 capital framework will need to be reviewed.
Some of these factors may more appropriately be incorporated into supervisory assessments of individual AIs’ liquidity positions (i.e. whether an AI assuming an exceptionally high level of liquidity risk might warrant an additional liquidity buffer) once the new Liquidity Coverage Ratio is implemented in 2015.
123. Subject to industry feedback, the HKMA plans to conduct a full review of the Pillar 2 framework with a view to making any necessary modifications in the first half of 2012 to prepare for implementation by AIs on 1 January 2013.
These modifications will be incorporated into the SPM module “Supervisory Review Process” (CA-G-5) and the industry will be consulted in due course.
32 One overarching objective of the G-SIB policy measures is to reduce the negative externalities caused by the distress or default of a G-SIB, by reducing both the probability of default and the loss to society given default.
Section 4
Implementation timetable
124. As noted in paragraph 9, the HKMA intends to follow the transitional timeline set by the Basel Committee for implementing the Basel III capital standards in Hong Kong. Generally speaking, locally incorporated AIs should be relatively well-placed to meet the new capital requirements as they have tended to be conservative in their capital management, holding capital in excess of the minimum required levels and placing significant reliance on common equity as a constituent of their capital base. Consideration has therefore been given as to whether the Basel III capital standards should be adopted in Hong Kong in advance of the Basel Committee’s transitional timeline. However, in view of the present uncertainties affecting the markets and economies in many jurisdictions and the potential spillovers and effects on global growth, the HKMA’s current thinking is to adopt a “steady as we go” approach.
125. Following the Basel Committee’s transitional timeline should ensure that AIs are able to meet the new standards through reasonable earnings retention, capital or fund raising, and other balance sheet adjustments, while continuing to support economic activity through lending and other banking business. For ease of reference, the transitional timeline which the HKMA proposes to adopt for (i) phasing-in the minimum capital requirements, capital buffers and new capital deductions, and (ii) phasing-out capital instruments and minority interests that are no longer eligible for inclusion in the capital base is set out in Annex 7.
126. The HKMA will continue to monitor the approaches taken to the adoption of the Basel III capital standards in other major financial centres, including the timeline for adoption, and should there be significant negative implications for Hong Kong (for example in terms of any suggestion that the capital positions of AIs in Hong Kong are becoming relatively weaker as banks in early implementing jurisdictions strengthen their capital bases) the HKMA may revisit its approach and consider whether early implementation of some aspects of the Basel III package may be warranted in light of prevailing circumstances (including the level and trend of AI’s capital positions at the relevant time).
Annex 1
Criteria for classification as ordinary shares for regulatory capital purposes
1. Represents the most subordinated claim in liquidation of the bank.
2. Entitled to a claim on the residual assets that is proportional with its share of issued capital, after all senior claims have been repaid in liquidation (i.e. has an unlimited and variable claim, not a fixed or capped claim).
3. Principal is perpetual and never repaid outside of liquidation (setting aside discretionary repurchases or other means of effectively reducing capital in a discretionary manner that is allowable under relevant law).
4. The bank does nothing to create an expectation at issuance that the instrument will be bought back, redeemed or cancelled nor do the statutory or contractual terms provide any feature which might give rise to such an expectation.
5. Distributions are paid out of distributable items (retained earnings included).
The level of distributions is not in any way tied or linked to the amount paid in at issuance and is not subject to a contractual cap (except to the extent that a bank is unable to pay distributions that exceed the level of distributable items).
6. There are no circumstances under which the distributions are obligatory. Non payment is therefore not an event of default.
7. Distributions are paid only after all legal and contractual obligations have been met and payments on more senior capital instruments have been made.
This means that there are no preferential distributions, including in respect of other elements classified as the highest quality issued capital.
8. It is the issued capital that takes the first and proportionately greatest share of any losses as they occur33. Within the highest quality capital, each instrument absorbs losses on a going concern basis proportionately and pari passu with all the others.
9. The paid in amount is recognized as equity capital (i.e. not recognized as a liability) for determining balance sheet insolvency.
10. The paid in amount is classified as equity under the relevant accounting standards.
11. It is directly issued and paid-in and the bank can not directly or indirectly have funded the purchase of the instrument.
33 In cases where capital instruments have a permanent write-down feature, this criterion is still deemed to be met by common shares.
12. The paid in amount is neither secured nor covered by a guarantee of the issuer or related entity34 or subject to any other arrangement that legally or economically enhances the seniority of the claim.
13. It is only issued with the approval of the owners of the issuing bank, either given directly by the owners or, if permitted by applicable law, given by the Board of Directors or by other persons duly authorised by the owners.
14. It is clearly and separately disclosed on the bank’s balance sheet.
34 A related entity can include a parent company, a sister company, a subsidiary or any other affiliate. A holding company is a related entity irrespective of whether it forms part of the consolidated banking group.
Annex 2
Criteria for inclusion in Additional Tier 1 Capital
1. Issued and paid-in.
2. Subordinated to depositors, general creditors and subordinated debt of the bank.
3. Is neither secured nor covered by a guarantee of the issuer or related entity or other arrangement that legally or economically enhances the seniority of the claim vis-à-vis bank creditors.
4. Is perpetual, i.e. there is no maturity date and there are no step-ups or other incentives to redeem.
5. May be callable at the initiative of the issuer only after a minimum of five years:
(a) to exercise a call option a bank must receive prior supervisory approval;
and
(b) a bank must not do anything which creates an expectation that the call will be exercised; and
(c) banks must not exercise a call unless:
(i) they replace the called instrument with capital of the same or better quality and the replacement of this capital is done at conditions which are sustainable for the income capacity of the bank35; or (ii) the bank demonstrates that its capital position is well above the
minimum capital requirements after the call option is exercised36. 6. Any repayment of principal (e.g. through repurchase or redemption) must be
with prior supervisory approval and banks should not assume or create market expectations that supervisory approval will be given.
7. Dividend / coupon discretion:
(a) the bank must have full discretion at all times to cancel distributions / payments37
(b) cancellation of discretionary payments must not be an event of default (c) banks must have full access to cancelled payments to meet obligations as
they fall due
(d) cancellation of distributions / payments must not impose restrictions on
35 Replacement issues can be concurrent with but not after the instrument is called.
36 Minimum refers to the regulator’s prescribed minimum requirement, which may be higher than the Basel III Pillar 1 minimum requirement.
37 A consequence of full discretion at all times to cancel distributions/payments is that “dividend pushers” are prohibited. An instrument with a dividend pusher obliges the issuing bank to make a dividend/coupon payment on the instrument if it has made a payment on another (typically more junior) capital instrument or share. This obligation is inconsistent with the requirement for full discretion at all times. Furthermore, the term “cancel distributions/payments” means extinguish these payments. It does not permit features that require the bank to make distributions/payments in kind.
the bank except in relation to distributions to common stockholders.
8. Dividends / coupons must be paid out of distributable items.
9. The instrument cannot have a credit sensitive dividend feature, that is a dividend / coupon that is reset periodically based in whole or in part on the banking organization’s credit standing.
10. The instrument cannot contribute to liabilities exceeding assets if such a balance sheet test forms part of national insolvency law.
11. Instruments classified as liabilities for accounting purposes must have principal loss absorption through either (i) conversion to common shares at an objective pre-specified trigger point or (ii) a write-down mechanism which allocates losses to the instrument at a pre-specified trigger point. The write-down will have the following effects:
(a) reduce the claim of the instrument in liquidation;
(b) reduce the amount re-paid when a call is exercised; and
(c) partially or fully reduce coupon / dividend payments on the instrument.
12. Neither the bank nor a related party over which the bank exercises control or significant influence can have purchased the instrument, nor can the bank directly or indirectly have funded the purchase of the instrument.
13. The instrument cannot have any features that hinder recapitalisation, such as provisions that require the issuer to compensate investors if a new instrument is issued at a lower price during a specified time frame.
14. If the instrument is not issued out of an operating entity or the holding company in the consolidated group (e.g. a special purpose vehicle – “SPV”), proceeds must be immediately available without limitation to an operating entity38 or the holding company in the consolidated group in a form which meets or exceeds all of the other criteria for inclusion in Additional Tier 1 capital.
38 An operating entity is an entity set up to conduct business with clients with the intention of earning a profit in its own right.
Annex 3
Capital Conservation Buffer
In order to increase the resilience of the banking system and to address procyclicality to some degree, the Basel Committee has introduced a capital conservation buffer as an integral part of the Basel III capital reform package. The capital conservation concept requires banks to build-up and hold a buffer of CET1 Capital in excess of the
In order to increase the resilience of the banking system and to address procyclicality to some degree, the Basel Committee has introduced a capital conservation buffer as an integral part of the Basel III capital reform package. The capital conservation concept requires banks to build-up and hold a buffer of CET1 Capital in excess of the