Supervisory Policy Manual

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Supervisory Policy Manual

LM-1 Regulatory Framework for Supervision of Liquidity Risk

V.2 (consultation)

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.

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Purpose

To provide guidance to AIs on the application of the Banking (Liquidity) Rules.

Classification

A statutory guideline issued by the MA under the Banking Ordinance,

§7(3)

Previous guidelines superseded

LM-1 “Liquidity Risk Management” (V.1A) dated 01.04.11 Application

To all AIs Structure

1. Introduction

2. Approach to supervising liquidity risk 3. Statutory liquidity requirements

3.1 Liquidity Coverage Ratio (LCR) 3.2 Liquidity Maintenance Ratio (LMR)

3.3 Implementation of LCR or LMR on Hong Kong office basis, unconsolidated basis and consolidated basis

3.4 Notification of liquidity events and supervisory responses 3.5 Internal targets and limits

4. Determination of category 1 and category 2 institutions

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4.1 General

4.2 Designation of category 1 institutions 4.3 Revocation of designation

4.4 Application for designation (or revocation of designation) 4.5 Ongoing review of designation

5. Application of LCR 5.1 Structure of LCR

5.2 High quality liquid assets (HQLA) 5.3 Level 1 assets

5.4 Level 2A assets 5.5 Level 2B assets

5.6 Ceilings on level 2 assets

5.7 Alternative Liquidity Approach (ALA) 5.8 Total net cash outflows

5.9 Monetization of HQLA under financial stress 6. Application of LMR

6.1 Structure of LMR 6.2 Liquefiable assets 6.3 Qualifying liabilities

6.4 Deductions from qualifying liabilities 7. Liquidity disclosure standard

7.1 Disclosure of LCR or LMR information

7.2 Disclosure of information on liquidity risk management

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7.3 Other liquidity information 7.4 Disclosure policy

Annex 1: Assets regarded as “free from encumbrances” under LCR or LMR Annex 2: Guidance on treatment of RMBS under LCR or LMR

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1. Introduction

1.1 Liquidity risk is the risk that an authorized institution (AI) may not be able to meet its obligations as they fall due without incurring unacceptable losses. This may be caused by an AI’s inability to liquidate assets or to obtain funding to meet its liquidity needs, whether because of institution-specific reasons or market stress.

1.2 Liquidity problems can have an adverse impact on an AI’s earnings and capital and, in extreme circumstances, can lead to the collapse of an AI. A liquidity stress besetting individual AIs that play an active or major role in financial activities may have systemic consequences for other AIs and the banking system as a whole. It could also affect the proper functioning of payment systems and other financial markets. Sound liquidity risk management is therefore pivotal to the viability of every AI and the maintenance of overall banking stability.

1.3 To promote the resilience of banks and banking systems to liquidity stress, the Basel Committee on Banking Supervision (BCBS) has issued a set of Principles for Sound Liquidity Risk Management and Supervision to strengthen international standards in this area. In addition, two quantitative metrics have been introduced by the BCBS as minimum international standards for liquidity management and supervision:

 the Liquidity Coverage Ratio (LCR), which came into operation from 1 January 2015; and

 the Net Stable Funding Ratio (NSFR), which will commence effect from 1 January 2018. (The local regulations implementing the NSFR will be issued in due course.)

1.4 In Hong Kong, it is one of the ongoing minimum criteria for authorization (provided in paragraph 7 of the Seventh Schedule to the Banking Ordinance (BO)) that the Monetary Authority (MA)¹ should be satisfied that an AI, on and after

1 In this module, the term “MA” refers to “Monetary Authority” (the person exercising the legal authority under the Banking Ordinance) or “Hong Kong Monetary Authority” (the office of the Monetary Authority), as the context so requires.

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authorization, maintains adequate liquidity to meet its obligations as they will or may fall due; and complies with the rules² made by the MA under §97H(1) of the BO. In this regard, the MA has made the Banking (Liquidity) Rules (BLR) under

§97H(1) to prescribe the requirements in respect of –

 the LCR, which is applied to AIs designated by the MA as “category 1 institutions”; and

 the Liquidity Maintenance Ratio (LMR), a local liquidity standard developed by the MA for application to all other AIs that are not designated as category 1 institutions, and which are referred to as “category 2 institutions”.

1.5 Moreover, the MA has issued a Code of Practice³ (the Code) under §97M of the BO to supplement the implementation of the LCR. Standard calculation templates are also included in the Return of Liquidity Position of an Authorized Institution (MA(BS)1E) to facilitate the calculation and reporting of the LCR or LMR by different categories of AIs.

1.6 This module (i) provides an overview of the regulatory framework adopted by the MA for supervising AIs’ liquidity risk;

and (ii) sets out the approach the MA will take in assessing AIs’

compliance with the statutory liquidity requirements provided in the BLR.

1.7 Failure of an AI to adhere to the guidelines in this module may call into question whether the AI continues to satisfy the authorization criterion set out in paragraph 7 of the Seventh Schedule to the BO.

1.8 AIs are also reminded that merely complying with the statutory liquidity requirements in the BLR or meeting the guidelines set out in this module is not of itself sufficient to constitute prudent liquidity risk management. In particular, AIs should adopt additional sound systems and controls tailored to their liquidity risk profiles, having regard to the size, nature and complexity of

2 Unless otherwise specified, any “rule” cited in this module means a rule included in the BLR.

3 This refers to the Banking (Liquidity Coverage Ratio – Calculation of Total Net Cash Outflows) Code, issued by the MA in December 2014.

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their businesses and activities. Please refer to the Supervisory Policy Manual (SPM) module LM-2 “Sound Systems and Controls for Liquidity Risk Management” for details.

1.9 This module should be read in conjunction with the BLR, the Code, the Completion Instructions (CIs) for Return MA(BS)1E, SPM module LM-2 and other relevant supervisory documents that may be issued by the MA. The terms used in this module have the meanings used in the BLR or the Code, as the case may be, unless otherwise specified or the context otherwise requires.

2. Approach to supervising liquidity risk

2.1 A key supervisory objective of the MA in respect of liquidity risk is to seek to ensure that AIs can always meet their obligations as and when they fall due, and for this purpose to assess the adequacy of AIs’ overall liquidity risk management frameworks and liquidity positions so as to endeavour to reduce the frequency and severity of liquidity problems affecting AIs and to reduce any potential impact on the banking system. is to promote the resilience of AIs against liquidity risk, with a view to mitigating the risks of liquidity problems affecting AIs and the banking system. To achieve this objective, every AI is required to –

 maintain adequate liquidity in compliance with the minimum LCR or LMR requirement (whichever is applicable); and

 put in place sound systems and controls for the management of liquidity risk.

Furthermore, AIs will be expected to observe any other supervisory requirements as specified by the MA from time to time for the purpose of enhancing AIs’ liquidity risk management.

2.2 The MA adopts a risk-based supervisory approach to monitor AIs’ liquidity positions and assess the soundness of their liquidity risk management systems and controls through a combination of supervisory actions, including (but not limited to) risk-focused off-site reviews, on-site examinations and prudential meetings. See SPM module SA-1 “Risk-based Supervisory Approach” for details of the MA’s risk-based

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supervisory approach.

2.3 In the course of risk-based supervision, the MA conducts offsite analysis on an AI’s liquidity positions. The information required for analysis is primarily obtained via the AI’s regular submissions of the following returns:

 Return on Liquidity Position of an Authorized Institution (MA(BS)1E), which reflects an AI’s liquidity position as measured by the LCR or LMR;

 Return on Intraday Liquidity Position of an Authorized Institution (MA(BS)22), which reflects an AI’s intraday liquidity positions;

 Return on Liquidity Monitoring Tools (MA(BS)23), which reflects an AI’s liquidity profiles with respect to (i) the level of concentration of funding sources, (ii) the amount of unencumbered assets that may be used as collateral for funding purposes, (iii) committed facilities granted and received, (iv) maturity mismatch positions, and (v), in the case of a category 1 institution, LCR positions in individual currencies; and

 Return on Selected Data for Liquidity Stress-testing (MA(BS)18), which is used by the MA to collect information from locally incorporated licensed banks to facilitate supervisory stress-testing focusing on their short-term liquidity positions (covering 7 working days).

2.4 Where necessary, the MA may request an AI to provide additional information on the AI’s liquidity positions. For example, an AI may be requested to provide its internal cash- flow projections and liquidity stress-testing results, as well as information in respect of the associated methodologies and assumptions, to facilitate supervisory monitoring and review of the AI’s liquidity risk profile.

2.5 In addition to conducting offsite reviews, the MA may also conduct on-site examinations to evaluate an AI’s liquidity risk management systems and controls. The frequency and scope of coverage of such examinations are determined by the MA on a case-by-case basis, having regard to actual circumstances and the materiality of prudential concerns about

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a particular AI’s liquidity risk profile.

2.6 In the course of liquidity risk supervision, while the MA will have primary regard to whether an AI complies with the requirements of the BLR and the associated supervisory documents (including the Code, this module, SPM module LM-2, and the CIs for the various liquidity returns), the MA may also take into account the AI’s compliance with other relevant guidelines and sound practices, e.g. those set out in SPM modules IC-1 “General Risk Management Controls” and IC-5 “Stress-testing”.

2.7 The results of the MA’s offsite review and on-site examination of an AI’s liquidity risk position and liquidity risk management systems will be taken into account in determining the AI’s CAMEL rating, and in the case of a locally incorporated AI, the regulatory capital requirement under the Supervisory Review Process (see SPM module CA-G-5 “Supervisory Review Process”). Where considered necessary, appropriate supervisory measures may also be taken based on such reviews and examinations.

2.8 The MA also seeks to maintain effective communications with AIs’ Boards of directors, senior management, auditors, and, where applicable, with overseas supervisory authorities to discuss prudential issues relating to the relevant AIs, including their liquidity positions and risk management controls. Such communications may be undertaken in various forms of prudential meeting or in any other appropriate means to facilitate effective exchange of views and information.

3. Statutory liquidity requirements

3.1 Liquidity Coverage Ratio (LCR)

3.1.1 The LCR is a ratio, expressed as a percentage, of the total weighted amount of a category 1 institution’s “high quality liquid assets” (HQLA) to the total weighted amount of its “total net cash outflows” over 30 calendar days (the LCR period):

HQLA

LCR = --- x 100%

Total net cash outflows

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3.1.2 A category 1 institution must maintain an LCR of not less than the minimum required levels specified in rule 4(1) and 4(2) as follows:

2015 2016 2017 2018 2019 and after Minimum

LCR 60% 70% 80% 90% 100%

3.1.3 As provided in rule 4(3), failure of a category 1 institution to maintain the minimum required level of LCR will not constitute a contravention of rule 4(1) or 4(2) if, but only if, it is due to the institution’s monetization of its HQLA when the institution is undergoing significant financial stress and its financial circumstances are such as described in rule 6.

3.1.4 Specific guidance on the application of the LCR (including the monetization of HQLA by a category 1 institution under rule 6) is provided in section 5 below.

3.2 Liquidity Maintenance Ratio (LMR)

3.2.1 The LMR is a ratio, expressed as a percentage, of the amount of a category 2 institution’s “liquefiable assets”

to the amount of the institution’s “qualifying liabilities”

(after deductions) over a calendar month:

Liquefiable assets

LMR = --- x 100%

Qualifying liabilities (after deductions)

3.2.2 As required under rule 7, a category 2 institution must maintain an LMR of not less than 25% on average in each calendar month.

3.2.3 Specific guidance on the application of the LMR is provided in section 6 below.

3.3 Implementation of LCR or LMR on Hong Kong office basis, unconsolidated basis and consolidated basis

3.3.1 §97H(3) of the BO empowers the MA to apply liquidity

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requirement rules on different bases that may cover all or any part of an AI’s business operations.⁴ The manner in which the MA exercises this power is provided specifically in rules 10 to 12.

3.3.2 Under rule 10(1)(a), every AI, irrespective of its place of incorporation, must calculate its LCR or LMR, as the case may require, on the basis that covers all of its business in Hong Kong (Hong Kong office basis).

3.3.3 Rule 10(1)(b) requires further that an AI incorporated in Hong Kong having any overseas branches must calculate its LCR or LMR additionally on an unconsolidated basis covering all of its business in Hong Kong and overseas branches, unless the MA is satisfied that the liquidity risk associated with the business of an AI’s overseas branch is immaterial and hence approves, under rule 10(3)(a), the exclusion by the AI of any of its overseas branches from the calculation. In general, the MA may only grant this approval under limited circumstances, for instance, where an AI’s overseas branch has been inactive and will remain so for the foreseeable future.

3.3.4 Rule 11(1) provides that a locally incorporated AI having any associated entity (as defined in §97H(4) of the BO) may be required by the MA to calculate its LCR or LMR additionally on a consolidated basis, being the AI’s Hong Kong office basis or the unconsolidated basis (where applicable) plus one or more of its associated entities specified by the MA.

3.3.5 Moreover, the MA may, pursuant to rule 12, require a locally incorporated AI to calculate its LCR or LMR additionally on a specially tailored basis covering any part of the AI’s business in or outside Hong Kong. The application of rule 12 to a locally incorporated AI is likely to be considered by the MA only in exceptional circumstances, where the MA is of the opinion that the bases of calculation of the LCR or LMR required under

4 Please refer to §97H(3)(d) to (f) of the BO.

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rules 10 and 11 would be insufficient to reflect an AI’s liquidity risk profile.⁵

3.3.6 In determining the consolidated group of a locally incorporated AI for liquidity purposes, the MA may, to the extent practicable, seek to follow the scope of consolidation in respect of the AI for other regulatory purposes (for example, for the regulation of capital adequacy and large exposures). Nevertheless, this does not preclude the possibility that the MA may apply different scopes of consolidation to a locally incorporated AI for different regulatory purposes.⁶

3.3.7 In particular, for liquidity purposes, the consolidated group of a locally incorporated AI may include associated entities which may not be majority owned or controlled by the AI. In determining which associated entities of a locally incorporated AI should be included in the AI’s consolidated group for liquidity purposes, the MA will primarily have regard to (i) the respective liquidity risks that the entities concerned pose to the AI and (ii) whether the respective activities of such entities fall within any of the relevant financial activities as defined in rule 11.

3.3.8 As required under rule 13(1), a locally incorporated AI that calculates its LCR or LMR on a consolidated basis must give notice in writing to the MA of any of the matters concerning its associated entities that are specified in rule 13(2)⁷ as soon as is practicable after the institution becomes aware of the matter. This will

5 For example, if a locally incorporated AI is expanding the operation of an overseas branch or associated entity quickly and the MA is of the opinion that the liquidity risk arising from the operation may not have been reflected clearly in the AI’s LCR or LMR calculated on an unconsolidated basis or consolidated basis, the MA may require the AI to calculate its LCR or LMR covering the branch or associated entity on a stand-alone basis .

6 For example, whilst the MA usually does not require a locally incorporated AI to include its associated entities that are securities or insurance companies (hence subject to distinct capital requirements) in its consolidated group for regulatory capital purposes, the MA may instead require the AI to include such associated entities in the scope of consolidation for liquidity purposes if the MA considers that the liquidity risks posed by these entities to the AI are significant.

7 These matters basically relate to entities becoming (or ceasing to be) an AI’s associated entities and their principal activities (and changes in these activities).

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allow the MA to review the scope of consolidation for the application of the LCR or LMR to the AI.

3.3.9 When a category 1 institution calculates its LCR on a basis covering any branch or associated entity operating in a host country where the associated liquidity requirement is different from that in Hong Kong, the institution should apply the requirements set out in the BLR and the Code for calculating its LCR, unless in the circumstances where rule 22(2) applies to the institution.

In this case (i.e. where rule 22(2) applies), the institution should follow the requirements set out by the relevant banking supervisory authority in that host country insofar as the calculation relates to the retail deposits and small business funding of the institution’s branch or associated entity operating in that country. (Please refer to paragraphs 5.8.2 to 5.8.19 below for further guidance.) 3.4 Notification of liquidity events and supervisory responses

3.4.1 Under the BO and the BLR, AIs have various obligations to notify the MA of specified matters in respect of their LCR or LMR positions.

3.4.2 Under rule 5, a category 1 institution is obliged to notify the MA as soon as practicable of any anticipated change in its HQLA or total net cash outflows that will cause (or could reasonably be construed as potentially causing) its failure to maintain an LCR as required under rule 4(1) or 4(2) (where applicable). Likewise, every category 2 institution is subject to a similar requirement under rule 8 to report any anticipated change in its liquefiable assets or qualifying liabilities (after deductions) that may make it unable to maintain its LMR at a level not less than 25%. These notification requirements enable the MA to be alerted of any potential liquidity problem anticipated by an AI so that proactive measures can be taken as appropriate.

3.4.3 Moreover, rule 14 provides that, for the purposes of complying with the “prescribed notification requirements” set out in §97I of the BO, an AI must immediately notify the MA of any “relevant liquidity

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event” prescribed in rule 14(3), and provide the MA with any particulars of the event upon request.⁸ Such relevant liquidity events include –

(a) for a category 1 institution:

(i) the institution failing to comply with the minimum LCR requirement specified in rule 4 where such failure does not arise from the institution’s taking action (under rule 6) to monetize its HQLA to meet its financial obligations;

(ii) the institution taking, or being about to take, action under rule 6 to monetize its HQLA to meet its financial obligations to the extent that the action will cause (or could potentially cause) the institution’s failure to maintain an LCR as required under rule 4;

(iii) the institution having received a notice from the MA setting out the conditions under rule 16(1) to address an event falling within subparagraph (ii) above, but failing to comply with any of the conditions;

(iv) the institution, being a “rule 37 institution”⁹, failing to comply with rule 37(d), meaning that the institution fails to maintain an amount of HKD- denominated HQLA (that are level 1 assets) at a level not less than 20% of its HKD-denominated total net cash

8 Every director, chief executive and manager of an AI that fails to comply with a prescribed notification requirement applicable to the AI commits an offence under §97I of the BO.

9 A “rule 37 institution” refers to a category 1 institution that applies the provisions of rule 37 in the calculation of its LCR. That rule, in conjunction with the other rules provided in Division 4 of Part 7 of the BLR, prescribes the framework of one of the options from amongst the “alternative liquidity approaches” as provided by the BCBS (the ALA option). For further details of this framework, please refer to subsection 5.7 below.

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outflows; and

(b) for a category 2 institution: failing to comply with rule 7 (in respect of the 25% minimum LMR requirement).

3.4.4 In the case of a liquidity event that constitutes a contravention of the BLR (and hence §97H(6) of the BO), the MA may, after holding discussions with the AI, issue a notice to the AI pursuant to §97J of the BO, requiring it to take remedial action as specified in the notice. To the extent practicable, the MA will require the AI concerned to improve its liquidity position and rectify identified liquidity management problems within a reasonable timeframe. Where the circumstances warrant, the MA may take more serious supervisory measures to maintain the general stability of the banking system and protect the interest of depositors (including potential depositors).¹⁰

3.4.5 The MA’s potential supervisory responses to relevant liquidity events falling within the meaning of rule 14(3)(a)(ii) and rule 14(3)(a)(iv) are elaborated upon in subsection 5.9 below.

3.5 Internal targets and limits

3.5.1 As mentioned in paragraph 3.1.2 above, the MA has adopted a phase-in arrangement whereby the minimum LCR requirement will be stepped up steadily until it reaches 100% by 1 January 2019. The phased implementation of the minimum LCR requirement should not, however, be viewed by category 1 institutions as an opportunity to slow down the pace of conformance with the LCR requirements. To guard against this eventuality, the MA expects each category 1 institution to set up an internal target for its LCR position, taking into account the institution’s liquidity

10 These measures may include, for example, ring-fencing the institution’s business activities (including deposit-taking activities); reviewing the fitness and propriety of any person (including a controller, director, chief executive, or manager ) in the institution; exercising the powers under Part X of the BO to assume control over the institution, and suspending or ultimately revoking the institution’s authorization.

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risk profile and the need to incorporate a sufficient buffer to provide the institution with a “safety cushion”

above the regulatory minimum requirements.

3.5.2 A category 1 institution’s internal LCR target should be reviewed and approved by the Board (or a Board-level committee) of the institution¹¹ at least annually., and be properly documented in the institution’s liquidity risk management policy. The review should take into account, among other relevant factors, the annual increments in the minimum requirement during the phase-in period (2015 to 2018) and the historical trend of the institution’s LCR positions. For example, if a category 1 institution has maintained an LCR at a relatively low level or has exhibited a volatile trend in its LCR over a considerable period of time (say, during the past 12 months), it may need to provide for a more prudent “safety cushion” in its internal LCR target to ensure ongoing compliance with the regulatory minimum LCR requirement.

3.5.3 If a category 1 institution’s LCR has already reached a level that is above the minimum requirement in any of the years during the phase-in period, the institution should set its internal LCR target for the coming year at a level not less than it has already been able to achieve, until its internal LCR target is able to safely ensure full compliance with a 100% LCR requirement.

3.5.4 Similarly, the MA also expects each category 2 institution to set an internal target for its LMR position, taking into account the institution’s liquidity risk profile.

Such internal target should be documented properly and reviewed and approved by the Board (or a Board- level committee) of the institution at least annually.

11 InUnless specified otherwise, where there is a provision in this module to the effect that certain items should be reviewed or approved by the Board (or a Board-level committee) of an AI, it is acceptable, in the case of a category 1 institution which is an AI incorporated outside Hong Kong, it is acceptable to have the internal LCR target for its Hong Kong branch reviewed and approved by a risk managementsuch review or approval by a designated function at itsthe AI’s head office located outside Hong Kongprovided that such designation has been formally approved and documented by the AI’s Board.

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3.5.5 In line with the requirements set out in SPM module LM- 2 (sections 4 and 5), eachEach AI should conduct regular projections and stress-testing of its LCR or LMR position as part of its liquidity risk management process, in order to identify risk drivers that may lead to drastic fluctuations in its LCR or LMR. Where practicable, such projections and stress-testing should be conducted with reference to the guidance provided in sections 4 and 5 of SPM module LM-2. In addition, AIs should formulate prudent metrics and internal limits (e.g. making reference to LCR by currencies, or to cash flows in tenor buckets that are more granular than those required by the LCR/LMR) as supplementary controls to ensure compliance with the LCR or LMR requirements and enhance resilience to possible liquidity stress.

3.5.6 In the course of risk-based supervision, the MA may request an AI to explain the rationale for its internal liquidity target, and elaborate on its methodologies for conducting projections and stress-testing in respect of its liquidity position. If necessary, the MA may subject an AI to closer supervisory scrutiny, or expect it to raise its internal liquidity target within a reasonable timeframe, if the MA considers it prudent or reasonable. To facilitate our risk-based supervisory monitoring, an AI is expected to inform the MA when its LCR or LMR has fallen below its internal target level and has remained close to the statutory minimum required level for a considerable period of time (e.g. less than 5% above the statutory minimum required level for three consecutive days).¹² 4. Determination of category 1 and category 2 institutions

4.1 General

4.1.1 In view of the diversity of AIs in terms of the nature, size and complexity of their business operations, the MA considers it appropriate to tailor proportionate liquidity requirements for different types of AIs taking into account their specific characteristics.

12 This expectation to inform the MA does not replace any formal notification requirement under the BLR.

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4.1.2 The LCR and the LMR are both designed to promote resilience to short-term funding risks, but there are differences in their respective conceptual frameworks and structures. The characteristics and profiles of AIs designated by the MA as “category 1 institutions” are such that it is considered both appropriate and more prudent for them to be required to observe the more granular and stress-based LCR requirement. Other AIs not designated as “category 1 institutions” are regarded as “category 2 institutions” and are required to observe the LMR requirement.

4.2 Designation of category 1 institutions

4.2.1 Under rule 3(1), the MA may designate an AI as a category 1 institution if he is satisfied that any of the grounds specified in Part 1 of Schedule 1 to the BLR (Specified Grounds) is applicable to the AI. (In the case of an AI that applies for the designation but none of the grounds specified in Part 1 of that Schedule is applicable to the AI, please refer to subsection 4.4 below).

4.2.2 Ground 1: The AI is internationally active. In determining whether an AI is internationally active, the MA will assess the level of the AI’s international exposure, as measured by the aggregate amount of its external claims and liabilities, against a quantitative benchmark.¹³

13 The adoption of this measure recognises that an AI with a significant level of external claims and liabilities tends to be more vulnerable to spill-over effects from crises and shocks that may occur in other countries. The MA relies mainly on the data reported by the AI in Part I of the Return of International Banking Statistics (MA(BS)21A) to assess the level of its external claims and liabilities against the quantitative benchmark. Under this benchmark, the external claims and liabilities associated with an AI’s intra-group entities are not excluded on the premise that such claims and liabilities result from banking activity involving entities in different countries, and thus still pose a degree of cross-border risk to the AI concerned.

For the purpose of initial designation of category 1 institutions to accommodate with the commencement of the LCR requirement from January 2015, the MA, after consulting the local banking sector, set the quantitative benchmark at HK$250 billion in order to assess whether an AI should be regarded as being “internationally active” by reference to the level of its international exposure. This benchmark will be subject to review from time to time, taking into account the

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4.2.3 Ground 2: The AI is significant to the general stability and effective working of the banking system in Hong Kong. In assessing the level of significance of an AI to the local banking system, the MA will assess:

(a) the size of the AI’s business operation, as measured by the amount of its total assets (after provisions), against a quantitative benchmark¹⁴; and

(b) the AI’s role (including any special function undertaken) or level of participation in the local banking system or financial markets¹⁵. Primary focus is placed on whether the AI may act as a significant conduit for transmitting liquidity problems across AIs, or may have a significant impact on the local banking system, financial markets and/or other stakeholders (e.g. depositors, retail investors, etc.) should the AI get into financial difficulty or should the relevant financial role or function performed by the AI, or its participation in a particular market activity, be disrupted.¹⁶

prevailing circumstances of the local banking sector, including (but not limited to) the medium- to long- term trend of the banking sector’s aggregate amount of international exposure.

14 The adoption of this measure recognises that AIs with a sizable operation tend to pose a higher level of risk and have a potentially greater impact on local banking stability if they encounter financial problems. Having consulted the local banking sector, the MA set this benchmark at HK$250 billion for the initial designation of category 1 institutions. As with the other benchmark for AIs’ international exposure, this benchmark on the size of an AI’s operation will be subject to periodic review.

In the assessment of a locally incorporated AI without any overseas branch or an overseas incorporated AI, the benchmark is applied to the AI’s “total assets (after provisions)” covering its Hong Kong office position, as reported by the AI in the Return of Assets and Liabilities of an Authorized Institution (MA(BS)1). In the case of a locally incorporated AI that has overseas branch operation, the benchmark is applied to the AI’s “total assets (after provisions)” covering its unconsolidated position (i.e. the combined position of its Hong Kong office and all overseas branches), as reported by the AI in the Combined Return of Assets and Liabilities of an Authorized Institution (MA(BS)1B).

15 Such markets may relate to wholesale funding, derivatives, securitization or other traded markets.

16 The crucial roles that an AI may play, or important functions that it may undertake, in the local banking system include, but are not limited to, a banknote-issuing function and serving as a clearing and settlement bank for major payment and settlement systems in Hong Kong.

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4.2.4 Ground 3: The liquidity risk associated with the AI is material. For the purposes of rule 3, the MA will have special regard to the nature and complexity of an AI’s business operation and its risk profile, with a view to assessing whether there may be material liquidity risks inherent in such operation that warrant the application of a more sophisticated and granular liquidity metric (i.e. the LCR) to the AI.¹⁷

4.2.5 Ground 4: The AI is so connected to another AI (being a category 1 institution) that if the first-mentioned AI were not to be designated as a category 1 institution, such connection would prejudice, or may potentially prejudice, the calculation of the LCR by the second- mentioned AI, the calculation of the LMR by the first- mentioned AI, or both. As differences exist in the calibrationdesign of the LCR and LMR, there may be potential for connected AIs that are not in the same category (i.e. category 1 or category 2) to engage in a degree of regulatory arbitrage (e.g. through intra-group transfers of assets and liabilities) for the purpose of reducing their regulatory liquidity requirements. As a safeguard, if the risk of regulatory arbitrage for such connected AIs is considered high, the MA may decide to designate all of them as category 1 institutions even though they do not all meet one of the other grounds for such designation.

4.2.6 Where there may be a potential risk of regulatory arbitrage for a group of connected AIs, the MA will assess the risk based on the specific circumstances of the case. Some relevant factors for consideration include the corporate structure, business size and risk profile of the connected AIs concerned, and any track record of intra-group interactions observed in the

17 For example, the MA may assess, among other things, whether an AI is active in derivative, securitization and other structured financing transactions or has significant exposures to complex financial instruments, as well as the adequacy of its systems and controls for managing liquidity risks arising from such transactions or instruments.

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course of supervision.¹⁸

4.2.7 Whilst the MA expects that in most cases the indicators and benchmarks referred to in paragraphs 4.2.2 to 4.2.6 above will be sufficient for the MA to make the assessment, there may still be cases where an AI’s fulfilment of the Specified Grounds can only be observed by reference to other factors. In these cases, the MA will discuss the rationale behind the designation with the AI concerned.

4.2.8 The MA will adopt, as appropriate, a forward-looking approach in assessing AIs relative to the Specified Grounds by taking into account any forthcoming business plan or development affecting an AI (such as anticipated business expansion or contraction, mergers or acquisitions, or any other new, or change in, business strategy) that may result in the AI meeting, or no longer meeting, the Specified Grounds.

4.2.9 The MA will normally assess whether an AI should be designated under rule 3 on a single entity basis.

However, there may be circumstances that warrant a group approach to determining the designation of connected AIs (such as by consolidating the positions of the connected AIs as if they were a single entity) if, for example, the AIs’ business operations in Hong Kong are closely integrated, or there is a specific plan for merging the AIs’ business activities.

Restricted licence banks and deposit-taking companies

4.2.10 In general, it is not likely that the MA would designate restricted licence banks (RLB) or deposit-taking companies (DTC) as category 1 institutions in the light of their relatively small, simple and localised operations, which typically render the grounds specified in paragraphs 4.2.2 and 4.2.3 not applicable to these types of AIs. Nonetheless, the MA retains the

18 Concern over regulatory arbitrage relates mainly to those AIs which are connected to the category 1 institution but are not subject to the MA’s consolidated supervision in respect of their liquidity positions.

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power to designate an RLB or DTC as a category 1 institution if warranted by exceptional circumstances, in which case the MA will explain the underlying reasons for the designation to the AI concerned.

Consideration of overseas incorporated AIs under rule 3(4) 4.2.11 As provided by rule 3(4), the MA may decide not to

designate an AI as a category 1 institution in the circumstances specified in Part 3 of Schedule 1 to the BLR, notwithstanding that the AI may otherwise meet any of the Specified Grounds.

4.2.12 For instance, some overseas incorporated banks operating branches in Hong Kong are affiliated to international banking groups. Their branches in Hong Kong may be covered by their groups’ global liquidity management models and the consolidated LCR requirements imposed on their groups by the relevant home supervisors. In these circumstances, the MA considers it reasonable to allow some degree of reliance on the “group” liquidity of overseas incorporated AIs, and may apply rule 3(4) if the circumstances specified in §2 of Part 3 of Schedule 1 to the BLR are met:

(a) the AI is adequately supervised in respect of liquidity risk by the relevant banking supervisory authority of the place of its incorporation – The liquidity requirements and supervisory standards applicable to the AI on a group basis covering its Hong Kong branch should be comparable to international liquidity standards, including the LCR and the Principles for Sound Liquidity Risk management and Supervision set out by the BCBS; and

(b) the AI complies with the liquidity requirements in the place of its incorporation – Upon request by the MA, the AI should be able to demonstrate that its banking group (covering its Hong Kong branch) is able to meet the relevant liquidity requirements in its home

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country.

4.2.13 The MA may also, in its review of the criteria discussed in paragraph 4.2.12, take into account other related factors, such as –

(a) Global liquidity risk management system – The foreign banking group’s global liquidity risk management system should enable its Hong Kong branch to fulfil the MA’s liquidity requirements in all major aspects, including the requirements relating to the LMR as set out in the BLR (in case the AI concerned is not designated as a category 1 institution) and other relevant guidelines on liquidity risk management and controls, as specified in SPM module LM-2¹⁹; and

(b) Effective home-host information sharing arrangements – There should be in place effective communication and information- sharing channels between the MA and the foreign banking group’s home supervisor such that the MA is able to obtain supervisory opinions and relevant information from the home supervisor on the foreign banking group’s liquidity position on a timely basis.

4.2.14 The MA may utilise any available channels to obtain information for the assessment of the above “group factors” relevant to an overseas incorporated AI. For this purpose, the MA may communicate with the AI’s Hong Kong branch or head office, or initiate supervisory dialogues with the AI’s home supervisor if necessary.

Where appropriate, the MA may draw reference from the report on a country’s liquidity supervisory framework that

19 For example, the stressed liquidity needs of the Hong Kong branch have been duly taken into account in the group’s centralised liquidity pools and that there are credible arrangements to enable timely transfer of funds to the Hong Kong branch if necessary. Moreover, the AI should be able to demonstrate that there is no legal or regulatory impediment (such as exchange control or remittance restriction) in the home country that prohibits the foreign bank from transferring liquidity to its Hong Kong branch as and when necessary.

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may be issued by the BCBS under its Regulatory Consistency Assessment Programme.

Newly authorized AIs

4.2.15 In the case of new authorizations, the MA will consider whether the applying institution should be designated as a category 1 institution if it is authorized, by reference to the institution’s medium-term business plan (usually covering 3 years) and other information provided to the MA for authorization purposes. After authorization, the MA will monitor the institution’s actual operation to decide whether the designation should be maintained or changed.

4.3 Revocation of designation

4.3.1 Pursuant to rule 3(5), the MA may revoke the designation of an AI as a category 1 institution if the MA is satisfied that had the designation not been made, he would not now make the designation. Practically, this means that the AI concerned no longer meets any of the Specified Grounds that had originally prompted the MA to designate it as a category 1 institution, or such grounds will not be met in the near future (e.g.

due to a permanent change in the institution’s financial position, corporate structure or business strategy).²⁰ 4.4 Application for designation (or revocation of designation)

4.4.1 Decision by the MA under rule 3(1) and (5) may be made upon an application by an AI. Upon receipt of the AI’s application for designation as a category 1 institution, the MA will approve the application pursuant to rule 3(1) if –

(a) any of the Specified Grounds is applicable to the AI; or

(b) the MA is satisfied that both the grounds set

20 Temporary or sporadic changes are not regarded as sufficient grounds for the MA to designate, or revoke the designation of, an AI as a category 1 institution.

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out in Part 2 of Schedule 1 to the BLR are applicable to the AI. This means that the AI’s particular circumstances provide reasonable justification for it to be designated as a category 1 institution;²¹ and the AI has the capacity (including systems and resources) to comply with the LCR requirements.

4.4.2 In the case of a category 1 institution that applies for revocation of its designation as such, the institution must demonstrate to the MA’s satisfaction that the conditions set out in rule 3(5) (as elaborated in subsection 4.3 above) are no longer applicable to it, or will no longer be applicable to it starting from a specific date. The MA will review critically whether there is any case to revoke the designation of the applying institution.

4.4.3 Any AI seeking to apply for designation (or revocation of designation) as a category 1 institution should discuss its intention with the MA before submitting a formal application.

4.5 Ongoing review of designation

4.5.1 In the course of risk-based supervision, the MA may review whether a category 2 institution should be designated as a category 1 institution, or whether the designation of an AI as a category 1 institution should be revoked, for example, if the MA is aware of a significant change in circumstances in respect of the AI that may affect the MA’s decision under rule 3.

4.5.2 As required under rule 15, if a category 2 institution foresees any material change in its business plan or circumstances that may result in it satisfying any of the Specified Grounds, it must notify the MA as soon as practicable.

4.5.3 If the MA envisages the need to designate, or revoke

21 For example, an AI, being a part of a foreign banking group which implements the LCR at the group level, may have a case to seek designation by the MA as a category 1 institution for the sake of consistency with its group’s liquidity risk management framework.

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the designation of, an AI as a category 1 institution, the MA will enter into discussion with the AI concerned to explain the ground for making the change. When the MA’s decision is finally issued, the AI will be given a grace period to prepare for implementing the LCR or LMR requirement accordingly. ²² In these circumstances, the AI concerned will be expected to agree with the MA on an implementation plan in order to ensure the institution’s prompt compliance with the newly applicable requirement.

5. Application of LCR

5.1 Structure of LCR

5.1.1 The LCR has two components:

(a) The numerator is the total weighted amount of HQLA held by a category 1 institution, including the sum of weighted amounts of level 1 assets, level 2A assets and level 2B assets, net of any adjustments that may be caused by the applications of the ceilings on level 2 assets (see subsection 5.6) and the ALA option (see footnote 9 and subsection 5.7); and

(b) The denominator is the “total net cash outflows”, which means a category 1 institution’s “total expected cash outflows” after deduction of its

“total expected cash inflows”, where the amount of deduction shall not exceed 75% of the total expected cash outflows.

5.2 High quality liquid assets (HQLA) General

5.2.1 As a basic principle, a category 1 institution should

22 The grace period will be specified in the MA’s notice to be issued to the AI through the denotation of the effective date of the designation or revocation of designation, as the case may be. Normally, the length of the grace period will not be less than 6 months. A longer grace period may be allowed if the actual circumstances of an individual case so warrant.

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include assets as its HQLA only to the extent that they can be easily and immediately monetizable at all times within the LCR period with little or no loss of value. As provided in rule 25, a category 1 institution must not include an asset in its HQLA unless –

(a) the asset falls within a class of assets specified in Schedule 2 to the BLR and meets the qualifying criteria (if any) specified in that Schedule for that class of assets;

(b) the asset satisfies all the characteristic requirements specified in Schedule 3 to the BLR that are applicable to the asset;

(c) the asset satisfies all the operational requirements specified in Schedule 4 to the BLR that are applicable to the asset; and (d) the institution satisfies all the operational

requirements specified in Schedule 4 to the BLR that are applicable to the institution insofar as those operational requirements relate to the asset.

5.2.2 Category 1 institutions should put in place appropriate systems and procedures to evaluate whether the requirements provided in rule 25 are satisfied in order for a particular asset to be included in an institution’s HQLA. This assessment should be conducted periodically by an appropriate function (e.g. risk management or compliance function) within the institution, and proper arrangements should be in place to ensure sufficient checks and balances in the assessment process.

Characteristic requirements

5.2.3 The characteristic requirements set out in Schedule 3 to the BLR are elaborated below:

(a) Low risk – The risks (including, for example, credit risk, interest rate risk, legal or any other types of risk) associated with the asset

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should be sufficiently low, so that they do not prejudice the asset’s ability to be monetizable.

For example, high credit standing of the issuer and a low degree of subordination increase an asset’s liquidity. Low duration²³, low legal risk, low inflation risk and denomination in a convertible currency with low foreign exchange risk all enhance an asset’s liquidity.

(b) Ease and certainty of valuation – The value of the asset should be readily identifiable and measurable, and can be readily agreed on by parties to a transaction involving the asset, whether by reference to the asset’s book value or current market price, or a simple valuation method or pricing formula based on publicly available market data.

(c) Simple structure – If the asset is a structured financial instrument, the structure of the instrument should be simple and standardised and it should not inhibit valuation or risk assessment. This implies that most structured financial instruments are usually not recognised as HQLA, except qualifying covered bonds and residential mortgage-backed securities (RMBS).

(d) Low correlation with risky assets – The asset should not have a strong correlation with another asset that carries material risks, nor should it significantly expose the holding institution to specific wrong-way risk or general wrong-way risk. ²⁴ For example,

23 Duration measures the price sensitivity of a fixed income security to changes in interest rate.

24 “Specific wrong-way risk” has the meaning given in §226A of the BCR. It means the risk that arises when the exposure to a counterparty is positively correlated with the probability of default of the counterparty due to the nature of the transactions with the counterparty.

“General wrong-way risk” has the meaning given in §1(h) of Schedule 2A to the BCR. It means the risk that arises when the probability of default of counterparties is positively correlated with general market risk factors.

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securities issued by financial institutions are usually not qualified for inclusion as HQLA, save for a limited number of exceptions, such as qualifying covered bonds and RMBS, and securities issued by a financial institution which is a public sector entity (PSE).

(e) Active and sizable market with low volatility – If the asset is traded in a secondary market (whether for outright disposal or securities financing transactions), the market should be active and sizable such that the asset can be readily monetized without a substantial discount or haircut to its market price.²⁵ The historical volatility associated with the trading prices and spreads of the asset should be demonstrably low. In this regard, specific thresholds on price volatility are set out in §4 to §8 of Part 3 of Schedule 2 to the BLR as one of qualifying criteria for the inclusion of specific types of assets as HQLA – please refer to paragraphs 5.4.1(a)(iii) and (b)(iii), 5.5.2(a)(ii) and paragraph 3(d) in Annex 2.

(f) Listed on a developed and recognized exchange – If the asset is listed on an exchange, the exchange should be a

“recognized exchange”. Generally, this may include any recognized exchange as defined under §2(1) of the Banking (Capital) Rules (BCR) (which refers to any of those exchanges specified in Part 2 or 3 of Schedule 1 to the Securities and Futures Ordinance).

25 In assessing this characteristic requirement in respect of an asset (such as marketable debt securities, covered bonds or RMBS), major factors for consideration include, for example:

 whether the asset is traded publicly in a recognized exchange (as referred to in paragraph 5.2.3(f)), or traded over-the-counter with a considerably large number of market participants;

 the availability of committed market makers to maintain the asset’s market liquidity;

 the levels and trends of the asset’s market transaction volume and pricing spread; and

 the robustness and efficiency of the clearing and settlement systems in respect of the asset market.

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(g) Denominated in convertible currency – The asset is denominated in Hong Kong dollars (HKD) or in a currency freely convertible into HKD.²⁶

5.2.4 In addition to the above characteristic requirements (as set out in Schedule 3 to the BLR), ideally an asset included by a category 1 institution in its stock of HQLA should be capable of being used by the institution as collateral to borrow intraday or overnight funding from the MA (or any overseas central bank). The asset ideally should also have the potential to benefit from a

“flight to quality” (meaning that its characteristics are such that it has the potential to attract investors to switch their funds into it) in times of stress.

Operational requirements

5.2.5 In addition to meeting the characteristic requirements stated above, any asset to be included by a category 1 institution as HQLA must be free from any operational restrictions that would prevent timely monetization of that asset during a stress period. The institution must have in place and maintain adequate operational capacity and systems to readily monetize any asset in its HQLA without being constrained by any internal business or risk management strategy.

5.2.6 Specific operational requirements set out in Schedule 4 to the BLR are elaborated below:

(a) any asset included by a category 1 institution as its HQLA should be –

(i) managed by a liquidity management

26 If a category 1 institution has a banking operation in an overseas country where the local currency is not convertible into Hong Kong dollar, the HQLA denominated in that local currency held by the banking operation in that country can only be used to cover the liquidity needs arising from the banking operation in that country. Therefore a category 1 institution should treat this portion of HQLA according to rule 23 or 24 (in respect of the treatment of “liquidity transfer restrictions”) in calculating its LCR on a consolidated basis or unconsolidated basis covering its overseas banking operation.

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function²⁷ designated by the institution for the purpose which has the continuous authority and legal and operational capability to monetize any asset in the institution’s HQLA; and (ii) maintained in a separate pool of

assets under the control of the institution’s designated liquidity management function with the sole intent of being used as a source of contingency funding, unless it is clear and can be demonstrated to the MA that the designated function as referred to in subparagraph (i) above can monetize any asset in the institution’s HQLA (irrespective of where it is maintained within the institution) and the proceeds are available to the designated function without direct conflict with the institution’s internal business or risk management strategy, at any time within a period of financial stress that lasts for 30 calendar days;

(b) a category 1 institution should be able to access relevant markets for monetizing assets in its HQLA as necessary. This ability should be tested or verified by periodical monetization of a representative portion of its HQLA in the relevant markets, unless this ability can be demonstrated satisfactorily through transactions conducted in the normal course of business operation;

27 Depending on the practical circumstances, the “liquidity management function” of an AI may be performed by a person, a functional department, or a committee. The composition, authorities and responsibilities of that function should be clearly delineated and approved by the institution’s Board (or Board-level committee), which assumes the ultimate governance responsibility over that function.

The head of the function should be a manager under the meaning of §72B of the BO, or a director or chief executive (or alternate chief executive) approved by the MA under §71 of the BO.