Camel Rating System and the Major Issues of Banking

Supervision in Hong Kong

Law, Ka Chung

School of Economics and Finance

The University of Hong Kong

April 1998
INTRODUCTION

During the 1980s, the US had a very serious crisis involving the banks, hence the deposit

insurance fund was seriously depleted. Had the Central Banks known the problem banks in advance,

they could have enacted early closure of problem banks with measures (Prompt Corrective Action,

PCA). Historically, the liquidity ratio was regarded as the most important indicator, but this was soon

proved to be inadequate. Hong Kong (HK) Government also committed such a mistake once in the

1980s. To cope with this problem, a new approach, the CAMEL rating system, was introduced.

CAMEL RATING SYSTEM

The system helps to identify institutions whose weaknesses in financial condition, compliance

with laws and regulations, and operating soundness. The 5 components of CAMEL are: Capital

adequacy, Asset quality, Management quality, Earning potentials, and Liquidity. Each component is

evaluated on a scale from 1 to 5, with 1 the highest rating (least degree of concern) and 5 the opposite.

The composite CAMEL rating (also ranges from 1 to 5) provides an assessment by examiners of the

overall strength of a banking institution. 1 The interpretation of the ratings are as follows:

Rating Interpretation
1 Sound in every respect, flawless performance
2 Fundamentally sound, only minor correctable weaknesses in performance
3 Remote probability of failure, flawed performance
4 Potential of failure, performance could impair viability
5 High probability of failure, critically deficient performance
Banks with ratings 1 or 2 are resistant to external economic and financial disturbances, and are not

likely to be constrained by regulatory oversight. Corrective (remedial) action has to be taken for

banks with rating 3 and PCA for banks with ratings 4 or 5.

1. Capital Adequacy

The Bank for International Settlement (BIS) proposed the Capital Adequacy Ratio (CAR) in

1988 which is agreed by most economists. It is the ratio of the Tier 1 and Tier 2 Capital to the total

risk-adjusted assets, and thereby also known as the Risk-Based Capital Ratio (RBC). 2 The higher the

ratio the greater the ability to handle illiquidity or insolvency. Banks need to ensure high level of

capital to maintain so that there is some disincentive to engage in aggressive cutting of margins. Also
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this places some constraint on over-expansion of the balance sheet which might otherwise arise, for

example from an increase in domestic liquidity as a result of inflows. According to the Basle

Committee of the BIS, the minimum CAR for banks is 8%. Banks are considered as well-capitalized

if CAR is more than 10%, undercapitalized if less than 8%, and significantly undercapitalized if less

than 6%.

2. Asset Quality

As banking businesses are full of risks, assets managers must concern not only the short-run

profit but also the assets safety and liquidity. Thus, banks are supposed to manage their asset structure

based on the following priorities: (a) primary reserves; (b) secondary reserves; (c) loans; (d)

investments for income. Primary reserves are cash items held to satisfy the required reserve ratio,

normal currency needs and cheques clearance. Secondary reserves consist of highly liquid short-term

securities as the backup for primary reserves. Loans are highly profitable to banks, but the default rate

is also high and is rather illiquid. So, setting loan amount limits, reviewing credit history and

repayment habits, communication, etc., are essential. Of course, for banks having residual assets for

investments, their assets quality is even better. 3

Loans, advances and portfolio investments are the most important assets. Examples of high

quality assets are mortgage loans (living place is a must to everyone) and T-bills. Shares are poor

assets as banks may go bankruptcy.

3. Management Quality

The management quality can be reflected from the banks’ policies and controls for evaluating

and monitoring different kinds of risks. They include: country (sovereign), transfer, currency, interest

rate, credit, and contingent liability risks. 4 Any mismanagement of the internal operations can lead to

the increase of the above risks.

4. Earning Potentials

The earning potentials can be evaluated as trends through time-series analysis, and then

compared with other competitors. Here “potentials” means the “availability” of earnings to meet the
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needs for growth and to cover expected losses. Therefore, what matters is not only the absolute

earning but also the expected growth of it.

5. Liquidity

The maintenance of adequate liquidity is the first line of defence for a bank in protecting itself

against an outflow of funds. There are however problems in devising a supervisory policy for

liquidity. First, there is no accepted international standard for setting liquidity requirements as there is

for capital adequacy. Secondly, the appropriate liquidity requirements vary widely between different

types of bank, notably between those carrying on retail and wholesale business. Further

complications arise in the case of branches of foreign banks where it is difficult to distinguish the

liquidity needs of the branch in the host country from those of the bank as a whole.

The mandated holdings of a particular amount of Government debt is one means which a

number of countries have used for coping with capital inflows. Liquidity is measured by liquidity

ratio (LR). Other kinds of indicators include “loansassets” and “{cash and securities}assets”. The

supervision for liquidity management can also be studied by maturity mismatch analysis (discussed

later).

COMMENTS

PCA is based only on RBC and LR. First, some studies argued that RBC frequently is a

lagging indicator of banking problems and often fail to identify severely troubled institutions in a

timely manner. Or earlier identification of potential problem banks will likely be associated with a

larger number of non-troubled banks inadvertently being identified as “troubled”. Second, LR

associated with the deterioration in a bank’s health is often delayed until the bank undergoes a

supervisory examination. Banks tend to be slow to provision for possible loan losses, often adding to

loan loss reserves only after the problems have been identified. Third, CAMEL rating includes far

more information (apart from those publicly available data like RBC and LR) than that of PCA’s in

identifying problem banks. This is because banks are repository of private information about their

loan customers, and managers have incentive to disclose positive rather than adverse information
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about their operations. Thus, the comprehensiveness of CAMEL ratings enable the earlier

identification of problem banks than the PCAs’ do.

From another perspective, raising LR threshold for defining problem banks can be costly if

too many banks are identified as problematic since resources are limited. On the other hand, remedial

actions are costly for the banks with little likelihood of failure but falsely identified as problematic.

Hence, most banks having a CAMEL rating of 5 would not have been identified as problem banks

under the PCA threshold. 5

With the implementation of the Federal Deposit Insurance Corporation Improvement Act

(FDICIA) requirement of annual supervisory examinations, CAMEL ratings would better reflect the

current health of banks.

BANKING SUPERVISION IN HONG KONG 6

The supervision of banks in HK is done by the Hong Kong Monetary Authority (HKMA), or

the Banking Commissioner of the Hong Kong Government before 4/93.

1. Operational Supervision

A. On-site Examinations

At the core of supervision is the on-site examination of individual institutions. The coverage

may range from an investigation of specific areas to a comprehensive review of an institution's

operations. On-site examinations provide a valuable opportunity to assess at first hand how an

institution is managed and controlled. They are particularly useful for verifying asset quality.

However, they are periodic in nature and hence cannot achieve continuous supervision.

During on-site examinations, the HKMA normally reviews the audit programme of the

internal auditors and their work, and discuss with the them their major findings to ascertain the

performance and adequacy of the institution’s internal audit function.

B. Off-site Reviews

(I). Extensive Reviews

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 The scope of extensive reviews ranges from regular analysis of statistical returns, covering

various aspects of the operations of authorized institutions, to an extensive annual review of the

performance and financial position of individual institutions.

(II). Prudential Meetings

Off-site reviews are usually followed by a prudential meeting with senior managers. Frequent

contacts are made with individual institutions at various levels of management as specific issues

arise.

C. Tripartite Meetings

Annual tripartite discussions are increasingly held with institutions and their external

auditors, normally upon the completion of annual audits. Matters discussed typically include the

annual audit, adequacy of provisions and compliance with prudential standards and the Banking

Ordinance. The HKMA may require both regular and ad hoc reports from auditors on such matters as

the quality of internal controls and the accuracy of its prudential returns. The second audit of the

financial matters may sometimes be required as well. Tripartite meetings are held between the MA,

senior managers of banks and their internal and external auditors.

Frequency 1994 1995 1996

On-site examinations 188 203 198
Extensive reviews 288 378 379
Tripartite meeting 88 135 151
Prudential meeting n/a 14 12
Total 564 730 740

2. Risk Management: Basle Committee Guidelines

A. Capital Adequacy and Bilateral Netting

HK agreed upon CAR in 9/1988, and fulfilled the minimum requirement (8%) by the end of

1989, which was 3 years ahead of the deadline. The average CAR for HK was 17.8% by the end of

1996, which was the strongest in the Asia. (In the US, 12% is already deemed as very good!) The MA

is empowered to specify a higher minimum CAR for any particular institution which may be up to

12% for licensed banks (LBs) and up to 16% for restricted licensed banks (RLBs) and deposit-taking

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companies (DTCs). They are also required to observe a trigger ratio which is 1% above the minimum

ratio as to provide an early warning signal of deterioration in capital adequacy. Locally incorporated

institutions are required to meet the ratio requirements on both a solo and consolidated basis.

Year 1992 1993 1994 1995 1996

CAR (%) 16 17 17.4 17.5 17.8

B. Market Risks

"Market risk" is defined as the risk of losses in on- and off-balance sheet positions arising

from movements in market prices, interest or exchange rates. In 1/96, the Basle Committee issued an

amendment to the Capital Accord to incorporate market risks. 7 Following consultation with the Hong

Kong Association of Banks (HKAB) and the Deposit-Taking Companies Association (DTCA) on the

Basle proposals, the HKMA implemented the market risk regime by the end of 1997, in line with the

deadline set by the Basle Committee. Under the regime authorized institutions incorporated in HK are

required to maintain adequate capital to support the potential loss arising from their market risks. This

is in addition to the capital required to support the potential loss arising from credit risks. That means,

for institutions which are subject to the regime, two CARs will be calculated: unadjusted and adjusted

(to incorporate market risks). Both ratios would need to be above the statutory minimum ratio already

set for each institution (and in practice above the trigger ratio).

The regime is applicable only to locally incorporated authorized institutions. The

responsibility for supervising the capital adequacy of foreign institutions rests primarily with the

respective home supervisors. As the majority of local institutions are not heavily engaged in

derivatives and trading activities and in order to reduce their reporting burden, institutions which

have only a limited amount of market risks may be exempted from the new capital requirement. Such

institutions are required only to calculate an unadjusted CAR. The calculation of adjusted CAR and

the conditions for its exemption are listed in Appendix A.

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 There are three methods for the measurement of market risks under the new regime: (a) the

Basle standardized approach; (b) the internal models approach; (c) The European Union CAD. The

detailed are listed in Appendix B.

The new regime will clearly be an improvement on crude supervisory systems which attempt

to control market risk by placing limits on the size of exposures which may be undertaken in the

securities and foreign exchange (forex) markets. 8 However, the new arrangements are not without

their own difficulties as is evidenced by the length of time which it has taken for them to be produced.

Institutions are also expected to have an established policy for allocating transactions into

their trading or non-trading (i.e., banking) book, as well as procedures to ensure compliance with

such policy. There must be clear audit trail at the time a transaction is entered into. The HKMA would

monitor institutions practices to ensure that there is no abusive switching between different books

designed to minimize capital charges.

C. Interest Rate Risk

The Basle Committee proposed a document on the problem of interest rate risk in 4/93. The

HKMA adopted the Committee’s proposal on 2/95. Authorized institutions are required to report

their interest rate risk quarterly.

D. Derivatives

The positions in derivatives of locally incorporated institutions are incorporated within the

market risk reporting framework. The HKMA has reviewed the joint Basle/IOSCO framework for

supervisory information on banks’ derivatives activities.

3. Risk Management: Others

A. Liquidity

The HKMA introduced on 1/8/94 a new regime for the supervision of authorized institutions'

liquidity. Under the new approach, the adequacy of liquidity is assessed having regard to six factors,

including liquidity ratio, maturity mismatch profile, ability to borrow in the interbank market,

inter-group transactions, loan to deposit ratio, and diversity and stability of the deposit base. The new
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approach aims to ensure as far as possible that: (a) institutions can meet their obligations when the fall

due in normal circumstances; and (b) they have the ability to cope with an abrupt withdrawal of funds

under crisis conditions. 10

The LR is the ratio of liquefiable assets which can be realized within 1 month to qualifying

liabilities with 1 month maturity. 11 All banks are required to maintain a LR of at least 25% of their

1-month liabilities, albeit by differing margins. There is no requirement to hold liquidity in

Government debt, though this is encouraged (partly as a means of obtaining access to the discount

window). However, they are required to set out their policy on managing their liquidity in different

currencies. Policy should take into account the liquidity needs of foreign branches and subsidiaries in

the event of liquidity crisis.

B. Loan Classification System

The HKMA introduced in 12/94 a new measure which requires authorized institutions to

report on a quarterly basis their assets according to a standardised loan classification system. The

objective is to enhance the HKMA's understanding of the loan quality of individual institutions and to

provide an overview of the loan quality of the banking industry as a whole. Under the system, assets
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are classified as Pass, Special Mention, Substandard, Doubtful or Loss, with the latter three

categories collectively regarded as classified assets. The system is supplemented by regular reporting

on provisions set aside for each category of classified assets and for different sectors in HK. Thus,

peer group comparisons are made easy, especially the adequacy of provisions against non-performing

loans. Also, it is possible to gain an industry wide picture of asset quality and changes in the overall

trend. 13

Pass Special Mention Substandard Doubtful Loss

AIs 97.07 1.91 0.40 0.54 0.09
Local banks 94.33 3.36 0.69 1.57 0.05

C. Monitoring of Property Related Lending

The quality of a property loan may be adversely affected by factors which the lending bank

has little control, like the general level of interest rates and the volume and direction of capital flows.
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Moreover, the funding of property lending will generally involve running a liquidity and interest rate

mismatch. These risks may become acute if capital flows reverse and interest rates have to be raised

sharply. 14
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The mortgage lending has traditionally been a very safe form of lending in HK.

Nonetheless, the elements of concentration and liquidity risks remain. In particular, the HKMA has

supported the application by banks of a loan to value ratio of not more than 70% in respect of their

residential mortgage lending. With property prices having fallen by up to 30% from their 4/94 peak,

this measure has provided the banks who lent at the top of the market with a prudential cushion during

the downturn.

D. Country Risk

The HKMA monitors institutions’ exposures to country risk on the basis of a return designed

specifically for that purpose. Institutions are required to report half-yearly their cross-boarder

exposures broken down by counterparty type and country. They are assessed by reference to the

country risk provisioning matrix developed by the Bank of England. 16

E. Forex Risk

Institutions are required to report to the HKMA their foreign currency positions (including

options) monthly. Locally incorporated ones are required to report their consolidated foreign

currency positions. The aggregate (the sum of long and short) net open position should normally not
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exceed 5% of the capital base and 10% for the individual net open position. In particular, for an

institution with high degree of market and system proficiency, the normal aggregate limit might be

higher than 5% but not exceed 15% of its capital base. Nevertheless, they all have report to the

HKMA any breaches of the agreed limits for such positions.

4. CAMEL Rating System

The CAMEL rating system applies to both locally incorporated institutions and branches of

foreign banks. The HKMA aims to review the CAMEL ratings of all institutions every year. The

composite rating will be disclosed to the board of directors and senior managers of an institution
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together with recommendations to strengthen its financial position or management. The board is

expected to take a close interest in managers’ efforts to rectify any problems underlying a composite

rating of 3 or below. The board and managers are required to keep the composite rating confidential

to avoid the risk of possible misinterpretation of the rating assigned to individual institutions.

5. Financial Disclosure

Depositors and shareholders should be provided with relevant, reliable and comparable

information on banks to enable the assessment of banks' performance. The HKMA has promulgated

minimum standards for financial disclosure. The standards are set out in “Best Practice Guide on

Financial Disclosure” issued in 1994. Banks now provide much greater detail about their information.

The information required to be disclosed includes: (a) the nature and quality of earnings and cost

structure; (b) actual profits; (c) the nature and quality of assets; (d) sources of funding; (e) capital

resources; (f) off-balance-sheet exposures; (g) principal accounting policies; (h) segmental reporting.

Banks are required to include the statement of compliance in the directors’ report, stating whether the

Guide has been fully complied with, and if not, the reasons for any non-compliance.

6. Money Laundering

The HKMA fully subscribes to the basic policies and principles to combat money laundering

as embodied in the Statement of Principles issued by the Basle Committee in 12/1988 and the FATF
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recommendations. The Statement seeks to deny use of the banking system to those involved in

money laundering by application of the principles which are listed in Appendix C.

In 7/93 a revised industry Guideline on Monetary Laundering was issued setting out the

standards and procedures expected of institutions in their record keeping, customer identification,

recognition and reporting of suspicious transactions. It has been further revised and re-issued in 10/97

to take account of more recent developments including the amendments to both OSCO and the

DTROP in 1995.

7. Organization of the Banking Supervision Department

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 Standardized formats were introduced for the Banking Supervision Department’s internal

off-site reviews and external on-site examination reports. Also, under the new arrangement of the

allocation of work responsibilities in 8/95, each member of a team is designated the case officer for a

number of institutions and works primarily on them. This aims at building up more in-depth

knowledge of staff members and develop closer contacts with those institutions.

8. Guidelines on Leveraged Forex Trading and Unsolicited Calls

Strictly speaking the leveraged forex trading is not a banking business, in which the

supervision belongs to the Securities and Futures Commission (SFC). For unsolicited calls, the

HKMA reached agreement with the SFC to exempt such calls by authorized institutions seeking to

sell leveraged forex contracts where the calls comply with guidelines issued by the HKMA.

9. Priority Payment to Small Depositors

The priority payment scheme was embodied in the Company Ordinance and put into

operation in 1995. Under this scheme, the first HK$100,000 net deposits of eligible depositors (all

depositors except persons connected with the bank being liquidated and other authorized institutions)

should receive priority payment in a liquidation of a licensed bank. The scheme applies to all eligible

deposits except RLB and DTCs.

10. Relationship with Other Supervisors

A. HK

The deregulation and growing internationalization of markets over the past decade has led to

the emergence of corporate groups providing a wide range of financial services which operate across

a wide range of countries. The supervision of the individual entities within a conglomerate must

therefore be complemented by an assessment from a group-wide perspective. Clearly, this requires

cooperation between different supervisions and the ability (and willingness) to exchange

information. The responsibilities of individual supervisors may be embodied in a Memorandum of

Understanding (MOU). The HKMA and the Securities and Futures Commission (SFC) have recently

concluded such a MOU within HK in order to define their respective supervision responsibilities
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more clearly, provide for exchange of information and minimize supervisory overlap and underlap of

institutions carrying on both securities and banking business.

Such MOUs can be useful, but with limitations. In particular, individual supervisors cannot

simply divest themselves of, or delegate, their statutory responsibilities through such MOUs.

Moreover, exchange of information must be subject to certain safeguards, including that there are

adequate means for the recipient supervisor to maintain confidentiality requirements. Regular

bi-monthly meetings are held at present.

Another example of supervisory co-operation were guidelines issued by the Technical

Committee of the International Organization of Securities Commission, and the communication with

the Insurance Authority.

B. Overseas

For institutions incorporated outside HK, the HKMA seeks assurances from the relevant

banking supervisory authority about the management and financial standing of the applicant, and also

information about the scope of that supervisor’s consolidated supervision. After institutions have

been authorized, the HKMA would maintain ongoing contacts with their home supervisors to

exchange information relating to the operations of these institutions. HK has now entered MOUs with

China, Macau and Indonesia on supervisory cooperation.

11. Legislative Changes

The Banking (Amendment) Ordinance 1995, which came into effect on 15/11/95, enhances

the HKMA's central banking role by establishing the HKMA as the licensing authority responsible

for the authorization, suspension and revocation of all three types of authorized institutions.

Decisions are taken on the basis of transparent and clearly defined authorization and revocation

criteria set out in Schedules to the main Ordinance. The Amendment Ordinance also improves checks

and balances in the authorization procedures by requiring the HKMA to consult the Financial

Secretary on important authorization decisions, such as suspension and revocation, and retaining the

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Chief Executive-in-Council as the appellate body for hearing appeals against decisions made by the

HKMA.

12. Code of Banking Practice

In 12/95, the Banking Advisory Committee (BAC) and the Deposit-Taking Companies

Advisory (DTCA) endorsed the proposal of the HKMA to develop with the banking sector a Code of

Banking Practice to cover such areas as the provision to customers of information about the terms and

conditions of banking services and the relevant fees and charges as well as the procedures for

handling customer complaints. It also helps to promote good banking practices and a fair and

transparent relationship between authorized institutions and their customers.

CONCLUSION

The general trend, and indeed the necessity, of banking supervision is to move towards what

the Chairman of the Basle Committee, Dr. Padoa-Schioppa, has called "market-friendly supervision".

Of course, all supervision is intended to be market-friendly in the sense that it is directed towards

maintaining the soundness of the financial market system. But the essence of the is to look for

solutions to supervisory problems within the market itself rather than by imposing a "top-down"

approach by the supervisors. Looked at from this point of view, the role of supervision is, in Dr Padoa

Schioppa's words, to strengthen "the disciplinary factors already present in the banking firm and the

market, and to complement them where they fail or where their failure would entail undue social

costs". This market-based approach is particularly relevant to dealing with today's more complex

world of free capital flows and fast moving financial market conditions and trading portfolios.

Notes:
1. The composite CAMEL rating may be changed between examinations if off-site monitoring indicates a significant
changes in the financial condition of the bank.
2. Tier 1 Capital (or Core Capital) consists of equity and perpetual non-cumulative preference stocks, and
undistributed profits. Tier 2 Capital (or Supplementary Capital) consists of inner reserves, certain revaluation reserves
and general provisions, other preference capital, and subordinated debt. Notice that capital is considered relative to the
size and type of institution. The risk-adjusted assets are the nominal value of assets adjusted by different weights of their
risks.

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3. During 1988-93 the bad debt charge of locally incorporated HK banks averaged only 0.25% of total assets compared
with as estimated 0.80% for selected US banks and 1.0% for UK banks during the same period.
4. Among the first three are specific to international lending. Interest rate risk is caused by mismatch of assets and
unpredictable interest rate movements; credit risk is due to borrower’s default; regulatory risk happens when there are
unfavourable regulations; contingent liability risk is because of customer’s withdrawals and drawdowns.
5. Most of the PCA early intervention restrictions apply only after the bank has fallen below the 4% threshold.
6. It is necessary to make the distinction between regulation and supervision, i.e., between direct and indirect controls.
Put briefly, regulation involves telling the banks what they can and cannot do in terms of running their business.
Supervision involves the establishment of a framework of rules and guidelines which are intended to establish minimum
standards of prudent conduct within which banks should be free, or at least more free, to take commercial decisions. The
latter approach allows the banks greater freedom to allocate credit in line with their own commercial judgement and is
thereby consistent with the general trend towards a market economy which is a feature of the Asian region.
7. The objective of the amendment is to ensure that institutions are holding appropriate capital against the price risks to
which they are exposed, particularly those arising from their trading activities.
8. In HK, banks are generally required to limit their forex open positions to not more than 5% of capital; although those
with a high degree of market proficiency might be allowed to go as high as 15%.
9. In this context the HKMA requested, when introducing the prudential return in 1996, institutions have to submit a
policy statement covering the definition of trading activities, the financial instruments that could be traded, and the
process for transferring positions into and out of the trading book. The HKMA will have regard to the institution intention
in entering into a particular transaction when determining whether such transaction should fall into the trading book.
Transactions will likely be considered to carry a trading intent if: (a) the positions arising from the transactions are marked
to market on a daily basis as part of the internal risk management process; (b) the positions are not (or not intended to be)
held to maturity; or (c) the positions satisfy other criteria the institution applies to its trading portfolio on a consistent
basis.
10. The first objective requires the banks to manage their funding and cash flow in a prudent manner on a day-to-day
basis. This means having regard to maturity mismatches which are being run, not putting too much strain on borrowing
capacity in the interbank market, trying to ensure a stable and diverse deposit base and maintaining a sensible loan to
deposit ratio. The second objective involves the holding of a stock of high quality liquid assets which can be run down in
a funding crisis in order to provide a breathing space during which liquidity support can be obtained from other sources.
In HK's experience, an institution's ability to survive a funding crisis depends to a great extent on its capacity to meet
depositors' withdrawals in the first few days. If the bank is basically sound and can get through this period, a run will tend
to die out naturally.
11. Liquefiable assets include cash, gold, net interbank placements, marketable debt securities, export bills and loan
repayments. Qualifying liabilities include customer deposits, net interbank borrowing and other liabilities. Discounts
(liquidity conversion factor, LCF) ranging from 0-20% are applied to the various types of liquefiable assets for
calculating the ratio.
12. Pass means borrowers are current in meeting commitments and full repayment of interest and principal is not in
doubt; Special Mention means borrowers are experiencing difficulties which may threaten the institution’s position
although ultimate loss is not yet expected; Substandard means borrowers are displaying a definable weakness which is
likely to jeopardise repayment and some loss is possible after taking account of the market value of security and
rescheduled loans; Doubtful means collection in full is improbable and the institution expects to sustain a loss of principal

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and/or interest, taking into account the market value of security; Loss means uncollectable after exhausting all collection
efforts.
13. By the end of 1996, the ratio of classified exposures to total credit exposures was 1.02% for the banking sector as a
whole and 2.31% for locally incorporated banks.
14. Even if the rates on property loans such as residential mortgages are variable at the discretion of the banks, there may
be practical constraints in raising sharply the interest cost of such loans. By doing so, banks may simply substitute credit
losses for interest rate losses as borrowers become unable to service their loans.
15. Such high quality is evidenced by the loan default rate of less than 0.5% of the outstanding amount. Indeed, a survey
carried out by the HKMA in 9/94 showed that the portion of residential mortgage loans which were more than 60 days
overdue was only 0.43% of total loans. It is also noteworthy that the fall in property prices of 30% or more from 4/94 to
10/95 did not create any significant problems for lenders.
16. Under this matrix approach country risk exposures are graded by reference to a number of factors to indicate the
degree of impairment or likelihood of repayment.
17. Under the linked exchange rate mechanism, positions in the HK dollar against the US dollar are excluded from the
guidelines on net open positions.
The principles laid down by the Basle Committee have subsequently been developed by the Financial Action Task Force
(FATF). In 2/1990, FATF put forward 40 recommendations aimed at improving national legal systems, enhancing the
role of financial systems, and strengthening international co-operation against money laundering. HK is a member of the
FATF and fully complies with the recommendations.
Appendix A
The adjusted CAR is calculated with the capital base expressed as a percentage of the total risk weighted
exposures (covering both credit risk and market risk). The components of this calculation are as follows:
1. market risk weighted exposures, being the sum of the capital charges for all market risk categories multiplied by
12.5;
2. credit risk weighted exposures, being the total net risk weighted exposures calculated in accordance with the Third
Schedule less that part calculated for on-balance sheet debt securities and equities in the trading book and on-balance
sheet positions in commodities; and
3. the capital base, which is the same as that calculated in accordance with the Third Schedule, i.e. the sum of Tier 1
and Tier 2 capital. Tier 3 capital, which is provided for in the Basle framework, is not permitted.
The criteria for granting de minimis exemption to an institution are as follows:
1. its market risk positions do not normally exceed 5% of its total on- and off-balance-sheet positions (and never
exceed 6%);
2. its market risk positions do not normally exceed HK$50 million (and never exceed HK$60 million);
3. its CAR is not less than 10%; and
4. the adjusted CAR is not more than one percentage point below the unadjusted CAR after incorporating the market
risk requirement.
All of the above criteria must be met in order for an exemption to be granted. The HKMA has separately advised
individual institutions of their exemption from the market risk capital requirement in 12/97. The assessment of the
institutions positions against the de minimis criteria was conducted on the basis of data reported by the institutions during
1997. The HKMA will rely on both on-site examinations and off-site reviews to monitor institutions compliance with the

15
exemption criteria on an on-going basis. Institutions which have been exempted from the market risk capital requirement
need only submit their return on market risk exposures on an annual basis, as of 31 December.
Appendix B
(a) This approach is used by most institutions which are subject to the market risk capital requirements. The method of
measuring market risks is set out in the completion instructions for the return on market risk exposures. It involves
standard formulae and risk weights applied to the various positions of the institutions.
(b) This method allows those institutions with the necessary systems to use their own internal risk management models
to measure market risks. The use of this approach is subject to the prior approval of the HKMA and will be subject to
various qualitative and quantitative conditions relating to the models themselves and the surrounding controls as set out in
the Basle proposals. Institutions will on a transitional basis be allowed to use a combination of the Basle standardized
approach and the models approach to measure their market risks. The partial models should however cover a complete
risk category (e.g. interest rate risk or forex risk). Institutions which are allowed to use the partial approach will be
expected to move towards a comprehensive model over time, i.e., one which captures all market risk categories.
(c) Some locally incorporated institutions are currently required to calculate their market risk capital requirements on
the basis of the CAD for group consolidation purposes. In order to avoid the need for such institutions to calculate the
market risk capital requirements on two different bases (i.e., Basle and CAD), the HKMA allows them to use the CAD to
measure market risks.
Appendix C
Specifically the HKMA expects that institutions should have in place the following policies, procedures and
controls:
1. Institutions should issue a clear statement of policies in relation to money laundering, adopting current regulatory
requirements. This statement should be communicated in writing to all management and relevant staff whether in
branches, departments or subsidiaries and be reviewed on a regular basis.
2. Instruction manuals should set out institutions' procedures for: (a) account opening; (b) identification of applicants
for business; (c) record-keeping; and (d) reporting of suspicious transactions.
3. Institutions should seek actively to promote close co-operation with law enforcement authorities, and should
identify a single reference point within their organization (usually a compliance officer) to which staff are instructed to
report suspected money laundering transactions promptly. This reference point should have a means of liaison with the
Joint Financial Intelligence Unit which will ensure prompt referral of suspected money-laundering transactions
associated with drug trafficking or other indictable offences. The role and responsibilities of this reference point in the
reporting procedures should be clearly defined.
4. Measures should be undertaken to ensure that staff are educated and trained on matters contained in this Guideline
both as part of their induction procedures and at regular future intervals. The aim is to generate and maintain a level of
awareness and vigilance among staff to enable a report to be made if suspicions are aroused.
5. Institutions should instruct their internal audit/inspection departments to verify, on a regular basis, compliance with
policies, procedures, and controls against money laundering activities.
Whilst appreciating the sensitive nature of extra-territorial regulations, and recognizing that their overseas
operations must be conducted in accordance with local laws and regulations, institutions should ensure that their overseas
branches and subsidiaries are aware of group policies concerning money laundering and, where appropriate, have been
instructed as to the local reporting point for their suspicions.

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16. The HKMA Home Page.

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