SUPERVISOR’S MEMO The use test for internal …

1 SUPERVISOR S MEMO39 HONG KONG MONETARY AUTHORITY QUARTERLY BULLETINDECEMBER What were the proposals in Min IRS onthe use test requirement? Min IRS proposes that an AI should have acredible track record in the use of informationgenerated by its internal rating systems(Paragraph ). The AI should alsodemonstrate that it has been using internalrating systems that are broadly in line with theminimum requirements for at least two yearsprior to qualification as an IRB AI. In particular, internal ratings and default and loss estimatesshould play an essential role in the creditapproval, risk management, internal capitalallocations, and corporate governance functionsof the , the use test should be applied to theinternal rating system as a whole rather than toindividual models within the system.

2 Thus, AIsmay not necessarily be using exactly the sameestimates for both IRB and all internal example, pricing models are likely to useprobability of default (PD) and loss given default(LGD) relevant to the life of the asset. AIsshould document and provide justifications forsuch How will the HKMA apply the two-yearuse test during the 2007-2009 transitionperiod? The HKMA has compared its use testrequirement against those of several otherleading jurisdictions. It focused on those withhome-host co-operation with the HKMA inrelation to foreign banking groups which haveAI subsidiaries planning to adopt the IRBapproaches between 2007 and 2009.

3 Anumber of these jurisdictions intend to reducethe use test requirement to one year forFoundation IRB (FIRB) applicant banks and twoThe use test for internal ratings - based approachesunder Basel IIUnder the Basel II framework, authorized institutions (AIs) intending to adopt theInternal ratings - based (IRB) Approaches to the calculation of the regulatory capitalcharge for credit risk are required to meet the use test requirement. The use testensures that rating systems and estimates are not designed and implementedexclusively for the purpose of qualifying for the IRB Approaches or used only to provideIRB the Basel II consultative document, Minimum Requirements for internal RatingSystems under the IRB Approach (Min IRS) issued in August 2004, the HKMA proposed that internal ratings systems should be implemented for a minimum of twoyears before being used for capital adequacy purposes.

4 In addition, in the SupervisoryPolicy Manual module, Validating Risk Rating Systems under the IRB Approaches (CA-G-4) issued in February 2006, the HKMA outlined its expectations concerning theareas in which these systems should be used internally by AIs. This memo explainsmore about the HKMA s use test requirement and the evidence of use it expects to seefrom the Banking Policy DepartmentSUPERVISOR S MEMOTHE use test FOR internal ratings - based APPROACHES UNDER BASEL IIHONG KONG MONETARY AUTHORITY QUARTERLY BULLETINDECEMBER 200640years for Advanced IRB (AIRB)

5 Applicant could create a situation where the parentbank would be subject to a shorter use testrequirement than its Hong Kong subsidiary,resulting in an undue burden on, and a delay to,IRB implementation in Hong Kong by foreignbanking groups. In this situation, the HKMA might need to exercise its discretion to reducethe two-year requirement case by case asprovided under Paragraph of Min , if it did so, the HKMA would alsoneed to have regard to the possible impact onlocal IRB , to maintain a level playing fieldamong the relevant AIs, the HKMA has decidedto reduce the time for which internal ratingsystems should have been in use to one year forall AIs intending to adopt FIRB during the three-year transition period 2007-2009.

6 AIsproposing to adopt FIRB after the transitionperiod and AIs planning to implement AIRB willremain subject to the two-year proposed change will bring Hong Kong intoline with the requirements of other leadingjurisdictions with which the HKMA has home-host What are the areas of use described inCA-G-4? As listed in Paragraph of CA-G-4, theareas of use include: credit approval pricing individual and portfolio limit setting credit monitoring (for example, higherrating review frequency for riskier obligors) analysis and reporting of credit riskinformation, including that for the Boardand senior management oversight determining provisioning modelling and management of economiccapital assessment of total capital requirementsfor credit risks under the AIs CapitalAdequacy Assessment Process (CAAP)

7 Assessment of risk appetite formulating business strategies (forexample, acquisition strategy of newexposures and collection strategy ofproblem loans) setting of, and assessment against,profitability and performance targets determining performance-relatedremuneration (for example, for staffresponsible for rating assignment andapproval) other aspects related to AIs riskmanagement (for example, informationtechnology systems, skills and resources,and organisational structure). Will AIs be required to use internal ratingsystems in all the areas described in CA-G-4?

8 based on further discussions with individual AIsand supervisors of other jurisdictions, theHKMA recognises that during the early years ofIRB adoption it will be difficult, in practice, forAIs to use internal ratings and default and lossestimates in all the areas of use set out inParagraph of CA-G-4. While this remainsa valid long-term goal, in the shorter term thereis a practical need for AIs to concentrate theirresources on the proper development,implementation, testing and validation of theirinternal rating systems. It will also take time forAIs management and business and riskSUPERVISOR S MEMOTHE use test FOR internal ratings - based APPROACHES UNDER BASEL II41 HONG KONG MONETARY AUTHORITY QUARTERLY BULLETINDECEMBER 2006management units to become accustomed tothe new credit risk management , in assessing compliance with the usetest.

9 The HKMA intends to allow AIs to extendthe use of their IRB systems gradually and inphases and to take into account the overallusage of the internal ratings and default andloss estimates for internal purposes by provision is closely aligned with theguidance on the use test recently published bythe Basel Committee ( The IRB use test :Background and Implementation , BaselCommittee Newsletter (September 2006),Basel Committee on Banking Supervision).AIs are required to demonstrate initial use of theinternal ratings and default and loss estimatesfor internal purposes in at least three areas setout in Paragraph of CA-G-4.

10 These are(a) credit approval, (b) credit monitoring, and(c) reporting of credit risk information to the AIs senior management and the Board of AI should also have a definite plan forextending internal use to the majority of otherareas specified in CA-G-4, where possiblehaving regard to the circumstances of individualAIs. The plan should be approved by the AIs Board of Directors or senior management, andis subject to the HKMA s What evidence of use will the HKMA require from AIs? AIs will need to demonstrate to the HKMA thatthey meet the use test requirement.