The Future of Prudential Regulation in Asia

1. The Future of Prudential Regulation in Asia David Carse Deputy Chief Executive Hong Kong Monetary Authority 9 November 1999

2. Introduction • Main focus will be on banking regulatory issues in the Region • The main challenge for regulators is to restore their banks to health in the wake of the Asian crisis and to keep them that way • has required “fire-fighting” measures to resolve problem banks and restructure banking systems • also requires ongoing improvements in prudential regulation and supervision • But there is also the longer-term strategic challenge of how to respond to global banking trends and increased competition

3. The reasons for the Asian crisis • The origins of the crisis are multi-faceted but weaknesses in domestic banking systems clearly played a major part • Inadequate prudential regulation and supervision must take part, but by no means all, of the blame for this

4. The nature of supervisory weaknesses • Lack of resources and expertise • Concern with form over substance • narrow focus on compliance with “regulations” rather than risk assessment • on-site examinations failed to detect problems • rules that did matter not always rigorously enforced (eg connected lending) • Lax loan classification and provisioning standards • concentration on historical overdues • too easy to restore NPLs to performing status

5. Regulation and supervision • Improvements in prudential regulation and supervision are being put in place • tighter rules on loan classification, provisioning and income recognition • increased capital requirements and prompt corrective action • foreign exchange and liquidity limits • tighter rules on connected lending and large exposures • tougher “fit and proper” requirements for owners and managers of banks • increased transparency • moves towards “risk-based” supervision • Greater autonomy for supervisors and in some cases new supervisory agencies

6. Risk-based supervision • This trend reflects the view that supervisors need to know more about the risks actually being run by their banks and the quality of the systems used for identifying, measuring and controlling these risks • more forward looking • preventative rather than curative • This will require major improvements in supervisory resources and capacity in the Region • Global standards like the Basel Committee’s Core Principles can assist in this process

7. The Basel Core Principles • Consist of 25 principles that establish the essential criteria for effective banking supervision • Intended to be used as a reference to identify deficiencies in national supervisory systems • Problem is that countries’ self-assessment of compliance tends to be over-optimistic • therefore need for review by independent third parties like the IMF • Compliance will be a factor in allowing low risk weightings in the revised Basel Capital Accord

8. The new Capital Accord • Three pillar approach towards capital adequacy • More differentiated approach towards risk weightings • Not yet a major preoccupation for most banks/supervisors in the Region who are still struggling to meet the old Accord • Most attention has so far been focused on the proposal to use the credit ratings of external agencies to determine risk weightings for capital purposes • concern about the accuracy of the agencies’ sovereign ratings and about increased pro-cyclical bias in capital requirements

9. Internationalization of regulation • The Core Principles and the new Accord are examples of the increasing trend towards common international supervisory standards and a greater preoccupation with enforcement of these standards • This is a good thing given the linkages between banking systems demonstrated by the Asian crisis

10. The need for greater regional cooperation • But the Asian regulators will increasingly have to find a common voice to ensure that they play a full part in the development of the common standards • hence the importance of regional groupings such as EMEAP

11. The strategic challenges for regulators • How to respond to increased global competition • protectionism versus liberalization • How to cope with technological change • electronic money • virtual banks • cross-border internet banking • How to ensure that domestic banks are equipped to meet these challenges • foreign ownership • consolidation

12. The Hong Kong response • Hong Kong is already one of the freest banking markets in the world, but there are certain anti-competitive elements • We have decided that these should be removed over the next three years • Liberalization package was announced in July 1999

13. Objectives of the liberalization package • Improve efficiency and innovation in the banking sector through increased competition • Provide incentives for local banks to think harder about merger and strategic alliances • Increase the attractiveness of Hong Kong as an international financial centre • Enhance the safety and stability of the banking system

14. The structure of the liberalization package • The reforms fall into two main categories • measures to remove competitive barriers in the market structure • measures to enhance the safety and soundness of the banking system

15. Removing barriers to entry • Improve access for foreign banks • number of permitted branches for post-1978 banks already increased from one to three • further relaxation to be considered in 2001 Q1 • will consider relaxation of other forms of entry (ie as banking subsidiaries), but no change before 2001 H2 • Allow wider access to the interbank payments system through the Real Time Gross Settlement system

16. Removing interest rate controls • Remaining Interest Rate Rules will be deregulated in two phases • Phase 1 (1 July 2000) • removal of interest rate ceiling on HK$ time deposits less than seven days • Phase 2 (1 July 2001) • removal of interest rate cap on HK$ savings accounts • allow interest to be paid on HK$ current accounts

17. Safety and soundness measures • Clarification of HKMA’s policy on Lender of Last Resort (done) • Study to enhance deposit protection (2000 H1) • Improvements to disclosure framework (ongoing) • Transition to more risk-based supervisory regime (ongoing) • Credit register for commercial enterprises (2000 H1) • Improve standards of corporate governance in banks (end-1999)

18. Conclusions • Asian regulators face formidable challenges • dealing with the aftermath of the Asian crisis which is by no means over for many banks • corporate restructuring • attempting to upgrade the quality of their supervisory policies and approach • effective application of bankruptcy laws • confronting a more competitive, complex and risky global environment • balancing liberalization and domestic stability and national interest issues

19. Conclusions (2) • Much has been done in the Region, but even more remains to be done • This will require the assistance of the international community, and for talk to be translated into action • While not denying the micro reasons for the Asian crisis, we should not overlook flaws in the international financial architecture which have not yet been fully addressed