Supervisory Policy Manual CR-G-5: Country Risk Management

Supervisory Policy Manual CR-G-5 Country Risk Management V.1 – 23.11.01 1 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. ————————— Purpose To provide guidance to AIs on the management of country risk Classification A non-statutory guideline issued by the MA as a guidance note Previous guidelines superseded Guideline 8.1 "Country Debt Provisioning" dated 13.12.93 Application To all AIs Structure

1. Introduction 1.1 Background 1.2 Types of country risk
2. Supervisory approach
3. Country risk management 3.1 Management oversight 3.2 Policy and procedures 3.3 Lending principles 3.4 Staffing and organisation 3.5 Country risk analysis 3.6 Country risk ratings 3.7 Country exposure limits

Supervisory Policy Manual CR-G-5 Country Risk Management V.1 – 23.11.01 2 3.8 Country exposure measurement 3.9 Monitoring and reporting system 3.10 Stress-testing 4. Country risk provisioning 4.1 Provisioning policy and approach 4.2 Location of provisions 4.3 Acceptance criteria for guarantees 4.4 Capital adequacy 5. Disclosure and regulatory reporting 5.1 Disclosure 5.2 Regulatory reporting Annex A: Key standards for sound financial systems —————————

1. Introduction 1.1 Background 1.1.1 When an AI engages in international lending or incurs a cross-border exposure, it undertakes not only customary credit risk but also country risk. Country risk is the primary factor that differentiates international lending from domestic lending. It encompasses all the uncertainties arising from the economic, social and political conditions of a country that may cause borrowers in that country to be unable or unwilling to fulfil their external obligations. 1.1.2 Country risk may arise from deteriorating economic conditions, political and social upheavals, nationalisation or expropriation of assets, government repudiation of external indebtedness, exchange controls and currency devaluation. 1.1.3 Country risk is a special form of risk over which AIs can exercise little direct influence. AIs should therefore ensure that they have adequate systems and expertise

Supervisory Policy Manual CR-G-5 Country Risk Management V.1 – 23.11.01 3 to manage their cross-border exposures and avoid taking undue concentration risks on such exposures. 1.1.4 The level of sophistication of an AI’s country risk management system (see section 3 below) should be commensurate with the size, nature and complexity of its cross-border exposures. 1.2 Types of country risk 1.2.1 AIs should be aware of the different types of country risk to which they may be exposed. The main categories of country risk comprise sovereign, transfer and contagion risk. 1.2.2 Sovereign risk denotes a foreign government’s capacity and willingness to repay its direct and indirect (i.e. guaranteed) foreign currency obligations. 1.2.3 Transfer risk is the risk that a borrower may not be able to secure foreign exchange to service its external obligations. Where a country suffers economic, political or social problems, leading to a drainage in its foreign currency reserves, the borrowers in that country may not be able to convert their funds from local currency into foreign currency to repay their external obligations. 1.2.4 Contagion risk arises where adverse developments in one country lead to a downgrade of rating or a credit squeeze not only for that country but also other countries in the region, notwithstanding that those countries may be more creditworthy and that the adverse developments do not apply to them. 1.2.5 Other categories of country risk include: • currency risk - the risk that a borrower's domestic currency holdings and cash flow become inadequate to service its foreign currency obligations because of devaluation; • indirect country risk – the risk that the repayment ability of a domestic borrower is endangered owing to the deterioration of the economic, political or social conditions in a foreign country where the borrower has substantial business relationship or interests; and

Supervisory Policy Manual CR-G-5 Country Risk Management V.1 – 23.11.01 4 • macroeconomic risk – the risk that the borrower in a country may, for example, suffer from the impact of high interest rates due to measures taken by the government of that country to defend its currency. 1.2.6 The risks described above may either be grouped conceptually as cross-border risk or “within foreign country” risk. The latter risk refers to situations in which exposures to a foreign country are denominated in and funded by that country’s domestic currency. Such exposures normally involve a lower degree of country risk than those funded by cross-border deposits. 2. Supervisory approach 2.1 Under Principle 11 of the Basel Committee’s “Core Principles for Effective Banking Supervision”, banking supervisors should be satisfied that banks under their supervision have adequate policies and procedures for identifying, monitoring and controlling country risk and transfer risk in their international lending and investment activities and for maintaining appropriate reserves against such risks. 2.2 In reviewing the effectiveness of an AI’s country risk management and the adequacy of provisions made, the HKMA will determine whether the AI: • has appropriate policies and procedures for the management of country risk; • has a robust system for assessing the country risk in its cross-border exposures; • has proper controls (e.g. through establishing and monitoring country exposure limits) in place to manage the concentration risk associated with such exposures; • devotes adequate resources to managing country risk; and • maintains adequate provisions for country risk. 2.3 The HKMA will have regard to the size and complexity of an AI’s cross-border business and other factors set out in this module in

Supervisory Policy Manual CR-G-5 Country Risk Management V.1 – 23.11.01 5 considering whether it has appropriate systems to control country risk and maintains adequate provisions for such risk1 . 2.4 It should be stressed that the primary responsibility for establishing adequate country management systems and determining the appropriate level of country risk provisions rests with an AI’s management. The HKMA will not normally stipulate requirements for the loan classification or provisioning level of exposures to specific countries experiencing repayment difficulties. AIs should not take this as a reason for deferring, or even not conducting, their own country risk and provisioning assessment. 2.5 The HKMA will conduct a regular review of the level of country risk provisions made by individual AIs. It may, on a case-by￾case basis, require AIs (particularly outliers in peer group comparisons) to re-assess their country risk provisions if there are grounds to doubt whether their existing provisioning level is adequate. 3. Country risk management 3.1 Management oversight 3.1.1 Effective oversight by an AI’s Board of Directors and senior management is critical to a sound country risk management process. 3.1.2 There should be procedures in place for the approval of an AI’s country risk management and provisioning policy (see subsection 3.2 below) and for ensuring that senior management adheres to that policy and implements appropriate measures to identify, monitor and control country risk. 3.1.3 The Board should review regularly the AI’s country risk exposures. Any significant changes in the conditions of a country should be brought to the attention of the Board promptly if the AI has substantial exposure to that country.

1 In the case of overseas incorporated AIs, the HKMA accepts that country risk management will usually be undertaken by their head offices on a group basis. Where the HKMA is not satisfied that the Hong Kong arm’s country risk exposures are adequately managed, it reserves the right to require measures to be taken by the AI concerned to make up for any deficiencies.

Supervisory Policy Manual CR-G-5 Country Risk Management V.1 – 23.11.01 6 3.2 Policy and procedures 3.2.1 AIs should have a clearly defined policy, documented in writing and approved by the Board of Directors, the Credit Committee or senior management under delegated authority, for country risk management and provisioning. 3.2.2 The policy may be subsidiary to, or form a part of, an AI’s overall credit policy or large exposures and risk concentrations policy (see subsection 5.2 of CR-G-8 “Large Exposures and Risk Concentrations”). 3.2.3 The details to be included in the policy, and any procedures drawn up in respect of them, depend on the nature and scope of an AI’s cross-border activities. Generally, they should set out the AI’s business strategy in overseas countries, the parameters under which such business is carried out, its risk appetite and risk tolerances in the light of available financial resources, staff skills and systems for country risk identification, measurement, monitoring, reporting and provisioning. They would normally include: • clear lines of authority (including approval of cross-border lending and exceptions), responsibility and accountability for country risk management; • types of country risk which may be incurred by the AI (see subsection 1.2 above) and the policies and procedures for managing them (in particular whether the AI’s country risk management process is centralised or decentralised and integrated with the AI’s overall credit risk management); • the overall limits and sub-limits for cross-border exposures (see subsection 3.7 below); • the standards and criteria which the AI will use to analyse the risk of particular countries; • the internal country rating system, if any, or how the country risk elements are factored into the AI’s existing loan classification system; • the method to be used in measuring country risk exposures;

Supervisory Policy Manual CR-G-5 Country Risk Management V.1 – 23.11.01 7 • the country risk provisioning policy and methodology (see subsection 4.1 below); • types of and criteria for acceptable collateral and guarantees (see CR-G-7 “Collateral and Guarantees” for details), financial instruments and hedging strategies (e.g. credit derivatives or netting arrangements) which are allowed to be used for the mitigation of country risk and the requirements for perfection of collateral; • the minimum standard terms and conditions to be incorporated in loan documentation in accordance with the legal requirements of each country; • the requirement for registration2 , if applicable, of credit granted and guarantees accepted, non￾compliance with which may render the exposure or guarantee not legally enforceable by the AI; • lists of designated lawyers for evaluating the legitimacy of documentation and perfection of collateral; • procedures for dealing with deteriorating situations in a country, with clear contingency plans and exit strategies; and • types of management reports on country risk. 3.2.4 The policy should be reviewed at least annually to determine if it is still appropriate for the AI's business and compatible with changing market conditions. 3.2.5 Senior management is responsible for monitoring implementation of the policy and developing detailed procedures, where necessary, to supplement the policy. 3.3 Lending principles 3.3.1 AIs should ensure that facilities granted to overseas borrowers are subject to the basic prudent credit￾granting criteria applicable to domestic exposures. For example, the principle of “know your customer” should

2 For example, AIs that are engaged in lending to Mainland-related entities should be aware of the requirement to register their foreign currency exposures to Mainland borrowers with the State Administration for Foreign Exchange.

Supervisory Policy Manual CR-G-5 Country Risk Management V.1 – 23.11.01 8 be upheld. See CR-G-1 “General Principles of Credit Risk Management” and CR-G-2 “Credit Approval, Review and Records” for more guidance. 3.3.2 There are many ways in which exposures can become related to countries and thus create risk concentrations. AIs should therefore ascertain the identity and the ultimate ownership of the borrowers, regardless of their place of incorporation and the complexity of their group structure. Where appropriate, AIs should obtain written evidence or confirmation from relevant parties of the identity of borrowers and their shareholder structure in name and percentage terms. 3.3.3 Credit should only be granted to creditworthy borrowers and due diligence should be carried out. AIs should not simply lend on the basis of the name or official status of a borrower or rely on any implicit governmental guarantee. AIs should satisfy themselves that the borrowers have sufficient foreign currency assets or income streams to service their foreign currency obligations. 3.3.4 AIs should not lend on the basis of inadequate information. While it may be difficult for borrowers in some countries to provide comprehensive financial data and audited accounts compiled in accordance with international accounting standards, AIs should not let that difficulty become an excuse not to ask for the information they need to assess a credit proposal. 3.3.5 As with all lending, AIs lending to overseas entities should verify what the funds are being used for and assure themselves that the proceeds are not being diverted to speculative investments in commodities, property or stock markets. Where funds are being used for a project, AIs should satisfy themselves that funds are not used for purposes other than financing the project. Frequent site visits and drawing by instalments can help to prevent the misapplication of funds. 3.3.6 AIs should not grant facilities to a particular economic sector purely based on government direction or benefits provided by the government such as tax concessions. They should place greater weight on borrowers’ repayment ability and the risks of and return from each transaction.

Supervisory Policy Manual CR-G-5 Country Risk Management V.1 – 23.11.01 9 3.3.7 Some countries are undergoing a process of economic development and restructuring. The infrastructure of commercial laws and regulations may not develop at the same pace. In larger countries, owing to the needs of different regions a lack of uniformity in laws and regulations and the interpretation of central directives by regional and provincial governments may exist. AIs should therefore beware of the assumption that what applies in one region or province applies in another. In case of need, AIs should seek advice from external counsel and get clearance from the relevant authorities. 3.3.8 Before accepting collateral covering overseas exposures, AIs should ensure that there has been full compliance with statutory procedures to strengthen validity and enforceability. Where tangible collateral such as land and buildings in the country concerned is taken, AIs should ensure that the pledgor has good title to the collateral and that any valuation reports are reliable. To this end, AIs should retain local lawyers who are thoroughly familiar with local laws, regulations and practices to check the legitimacy and enforceability of loan agreements, guarantees and other documentation. 3.4 Staffing and organisation 3.4.1 AIs should dedicate adequate resources to the country risk management process, taking into account the extent of their involvement in cross-border business. 3.4.2 AIs should ensure that their internal control systems for country risk management are adequate and the staff responsible for the function are competent and equipped with the necessary knowledge and skills to undertake their duties. They should undergo periodic training to update their skills and knowledge base. 3.4.3 The staff concerned should familiarise themselves with the financial and monetary system and legal and regulatory framework of those countries (or different regions/provinces of a country if there is a lack of uniformity in laws and regulations among them) to which the AIs have significant exposures and should seek independent professional advice where appropriate. 3.4.4 Country risk should preferably be managed on a centralised basis and integrated with an AI’s overall

Supervisory Policy Manual CR-G-5 Country Risk Management V.1 – 23.11.01 10 credit risk management. Responsibility for country risk may be assigned either to a senior executive (e.g. a country risk officer) or to an appropriate committee. AIs may also establish a specialised unit or department to analyse country risk (see subsection 3.5 below), propose country exposure limits and carry out regular country reviews. 3.4.5 Irrespective of the structure adopted, the functions of analysing country risk, setting limits and monitoring the AI's country risk exposures should be carried out by persons independent of the business development function. 3.5 Country risk analysis 3.5.1 AIs with significant cross-border operations should have robust systems for monitoring economic, social and political developments in the countries to which they have exposure. In assessing the risk of a country, AIs should consider both quantitative and qualitative factors of that country. 3.5.2 In developing quantitative assessments of the risk of a country, AIs may take into account the size and maturity profile of its external borrowing as well as its macroeconomic variables (including forecasts), fiscal, monetary, exchange rate and financial sector policies and relevant statistics. 3.5.3 Factors typically used in qualitative assessments of country risk include the quality of the policy-making function, social and political stability and the legal and regulatory environment of the country. In particular, AIs should have regard to the country’s compliance with international standards and codes, e.g. the 12 key standards and codes3 for sound financial systems highlighted by the Financial Stability Forum. These standards and codes are broadly accepted as representing minimum requirements for good practice.

3 The key standards and codes cover a range of areas including macroeconomic policy and data transparency, institutional and market infrastructure and financial regulation and supervision. Information on individual key standards is available from the Financial Stability Forum or relevant standard-setting bodies (see Annex A).

Supervisory Policy Manual CR-G-5 Country Risk Management V.1 – 23.11.01 11 3.5.4 AIs should give special attention to business dealings and transactions with counterparties from countries that do not sufficiently comply with international standards, e.g. those on the list of “Non-Cooperative Countries/Territories” published by the Financial Action Task Force on Money Laundering (“FATF”) from time to time. 3.5.5 Information on the progress of individual countries in implementing the above key standards and codes may be obtained from “Reports on Observance of Standards and Codes” (“ROSCs”)4 produced jointly by the International Monetary Fund (“IMF”) and the World Bank. 3.5.6 AIs should be aware of the impact of changes in governmental strategy and policies. This is particularly important if AIs have substantial credit exposures to a particular business sector or region in a country. The reduction or withdrawal of governmental support for a sector or region or changes in governmental policies may severely weaken the repayment ability of borrowers in that sector or region. AIs should therefore keep abreast of economic policy in the countries in which they do business so as to identify the right sectors for business development, to avoid those which are out of favour and to adjust their country business strategies in an appropriate and timely fashion. 3.5.7 AIs may make use of a variety of internal and external sources for assessing country risk. They should conduct their own country risk assessment, instead of relying entirely on external assessment. 3.5.8 In times of instability and impending crisis, AIs should consider taking appropriate actions, such as updating their analyses more frequently and expanding the scope of their country risk analysis. 3.5.9 AIs should maintain formal country risk analysis files. These files should be centralised at head office, with supplemental files in foreign branches or subsidiaries. 3.5.10 Country risk files should include:

4 Participation and publication of ROSCs is voluntary, although most countries that have undertaken standards assessment by the IMF and the World Bank have chosen to make them public.

Supervisory Policy Manual CR-G-5 Country Risk Management V.1 – 23.11.01 12 • analyses of political, economic and social issues of the country concerned; • situation reports submitted by country managers and credit officers; • call reports from visits to the country concerned; • reports from outside economic research services and major rating agencies; • published economic data and analysis; and • copies of documentation approving limits, sub￾limits and exceptions to limits. 3.5.11 The results of country risk analysis should be integrated closely with the process of formulating marketing strategies, approving credits, assigning country ratings (see subsection 3.6 below), setting country exposure limits (see subsection 3.7 below) and provisioning. 3.6 Country risk ratings 3.6.1 AIs should have a system in place to integrate the results of their country risk analysis (see subsection 3.5 above) into their internal ratings of borrowers. 3.6.2 AIs that have significant cross-border exposures or overseas investments and operations should consider establishing a formal country risk rating system. Detailed written policies and procedures for analysing, recommending and approving country credit risk ratings should be developed for this purpose. The sophistication of such systems should be consistent with the size and complexity of an AI’s cross-border exposures and operations. 3.6.3 Some key issues that AIs should consider in developing their country risk rating systems are set out below: • country risk ratings should be assigned at least annually to every country (in particular for countries in emerging markets) where AIs have substantial exposures. AIs should conduct an interim review of such ratings whenever a potential change occurs in the economic, political and social conditions of a particular country;

Supervisory Policy Manual CR-G-5 Country Risk Management V.1 – 23.11.01 13 • AIs should form an independent unit (e.g. an economics department) or committee to assign country risk ratings. Such ratings should reflect the results of their country risk analysis; • AIs should not solely rely on ratings assigned by external rating agencies but they may have regard to these ratings in forming their own assessment and for validating, on a regular basis, the effectiveness of their existing system; • AIs should clearly define their country risk rating categories (e.g. numerical or alphabetical) and the characteristics and coverage (e.g. types of country risk included and types of exposure covered) of each rating category under their rating framework; • AIs should integrate the country risk rating system with their loan classification framework. For example, if an AI assigns an unfavourable rating to a country, it may need to downgrade all its exposures relating to that country to “special mention” or below under the loan classification system5 ; and • AIs should also use their country risk rating system to determine the appropriate level of provisions. 3.7 Country exposure limits 3.7.1 AIs should have a system for establishing, maintaining and reviewing country exposure limits. Country exposure limits should be approved annually and revised during the year in response to substantive changes in a country’s risk profile. 3.7.2 An AI’s country risk management policy should clearly specify which department or committee has the authority to approve country exposure limits and sub-limits and to approve exceptions. Exceptions to country exposure limits should require authorization by senior

5 In some cases, AIs may decide not to downgrade the exposure based on its own merits. Such decisions should be properly documented and justified.

Supervisory Policy Manual CR-G-5 Country Risk Management V.1 – 23.11.01 14 management or, depending on the size of the exception, the Board of Directors. 3.7.3 Country exposure limits should be set based on prudential grounds. They should not be viewed as business targets to be met. To ensure objectivity, AIs should maintain a clear division of responsibility by separating the business development function from the limit setting and monitoring function. 3.7.4 AIs should ensure that the limits set for their cross￾border lending are compatible with their overall strategic goals and that they have the requisite resources to administer lending levels at the targets set. 3.7.5 AIs should set exposure limits for individual countries (particularly for countries in emerging markets) and sub￾limits to manage and monitor country risk. Country exposure limits should apply to all on- and off-balance sheet exposures to foreign obligors. 3.7.6 Sub-limits may be divided by the following criteria: • maturity (e.g. short term and long term); • type of borrower (e.g. financial institutions, sovereigns and corporates); • type of country risk (e.g. sovereign, transfer, “within foreign country”, etc.); • type of product (e.g. trade-related credits, self￾liquidating loans, project financing, derivatives and other off-balance sheet exposures, etc.) • secured and unsecured; • insured and uninsured; • industry or economic sector of the borrower; and • region. 3.7.7 The credit officers and other relevant staff of an AI should be made aware of the country exposure limits. 3.8 Country exposure measurement 3.8.1 Systems for measuring country exposures need to be tailored to the size and complexity of individual AIs’ international lending operations. There is no single

Supervisory Policy Manual CR-G-5 Country Risk Management V.1 – 23.11.01 15 method of measuring exposure which is appropriate for all AIs. 3.8.2 As a general principle, AIs should ensure that the system is comprehensive enough to capture all significant exposures and detailed enough to permit adequate analysis of different types of risk. To achieve this, AIs’ measurement systems, as a minimum, should: • be capable of making two separate calculations of their country exposure, with and without risk transfer; • measure country exposure on both a solo and a consolidated basis; • be able to measure different types of exposures (e.g. foreign exchange and interest rate contracts); and • provide a sufficient breakdown (e.g. by type of borrower, exposure, collateral, residual maturity, etc.) for analysis by country. 3.8.3 Exposure should take account not only of outstanding balances but of undrawn commitments. AIs should be conscious that, even where a commitment is not legally binding in principle, there may be a degree of moral pressure to honour drawings. AIs are recommended to follow a conservative approach in this regard. 3.9 Monitoring and reporting 3.9.1 As part of the credit monitoring process (see CR-G-3 "Credit Administration, Measurement & Monitoring") AIs should have a system in place to monitor their compliance with country exposure limits and sub-limits. Exceptions should be reported, approved and rectified as laid down in the country risk management policy. 3.9.2 AIs should regularly carry out country visits, including visits to their foreign branches and subsidiaries, and maintain direct contacts with authorities in relevant countries. They should also visit their major overseas borrowers at least annually. Geographic distances should not be used as an excuse for omitting normal monitoring procedures, such as regular visits to borrowers’ overseas production lines.

Supervisory Policy Manual CR-G-5 Country Risk Management V.1 – 23.11.01 16 3.9.3 AIs should perform periodic credit reviews and monitoring of their overseas exposures to identify unusual developments and, if appropriate, initiate necessary actions to protect their interests (see CR-G-2 “Credit Approval, Review and Records” and CR-G-3 “Credit Administration, Measurement and Monitoring” for further guidance). 3.9.4 AIs should have an effective system in place to generate management reports which are detailed enough for the senior management review and to identify exceptions in a timely manner. 3.10 Stress-testing 3.10.1 AIs should conduct stress-testing analysis of their country risk exposures as a way of monitoring actual and potential risks. 3.10.2 Such testing should include evaluation of the impact on an AI's country risk exposures, should various material underlying assumptions turn out to be wrong. 3.10.3 It should also include co-variance analysis to detect or cater for contagion risk, particularly for countries in the same region. 4. Country risk provisioning 4.1 Provisioning policy and approach 4.1.1 Country risk provisions generally refer to provisions set aside by AIs to absorb potential losses arising from its country risk exposures. 4.1.2 There are essentially two common approaches that AIs may adopt for country risk provisioning: • the first is to reflect country risk in provisions earmarked against their aggregate exposure to a particular country after accounting for risk transfer and specific provision made against credit risk (i.e. on a country basis); and • the second is to factor in an element of provision for country risk into specific provisioning for each individual exposure (i.e. on an individual obligor basis).

Supervisory Policy Manual CR-G-5 Country Risk Management V.1 – 23.11.01 17 4.1.3 Whichever approach is adopted, AIs should make sure that they have set aside adequate country risk provisions according to their assessment of the probability of losses arising from their cross-border exposures. They may not however need to make additional provisions solely for country risk if they are satisfied that the current level of specific and general provisions is already sufficient to absorb any potential losses due to both credit and country risks. 4.1.4 AIs should adopt a rigorous process for determining the appropriate level of provisions for their country risk. The process should be documented in their provisioning policy and approved by the Board of Directors, the Credit Committee or senior management with delegated authority. 4.1.5 Generally, there are three stages in the process of deciding an appropriate level of provision: • identifying countries with current or potential repayment difficulties; • analysing the nature of those difficulties and the extent of the country's problems; and • determining what proportion, at this point, of exposures to that country is unlikely to be repaid in full. 4.1.6 The policy should specify criteria for when to provide and how to calculate country risk provisions. It should also clearly indicate which party has the authority to decide the level of country risk provision. 4.1.7 The policy should also describe the accounting policy adopted for recording and disclosing such provisions in the accounts. That policy should be applied consistently. 4.1.8 Any country risk provisions made should be justifiable and properly approved and documented. AIs should agree such provisions, if material, with their external auditors. 4.1.9 Where an AI has an internal country risk rating system, it should clearly demonstrate how its country risk rating system links up with its provisioning methodology. 4.2 Location of provisions

Supervisory Policy Manual CR-G-5 Country Risk Management V.1 – 23.11.01 18 4.2.1 In some cases, overseas incorporated AIs may prefer to establish provisions in their country of incorporation even though the impaired assets are held in the Hong Kong branch. This approach is acceptable to the HKMA, though the right is reserved to seek confirmation, as appropriate, from the overseas head office and, if necessary, from the overseas supervisory authority that the provisions are adequate. 4.2.2 Some locally incorporated AIs which are subsidiaries of foreign banks may wish their parent banks to guarantee the value of the loans instead of making provisions. This is acceptable to the HKMA provided that the criteria set out in subsection 4.3 below are met. Such arrangements should be notified to the HKMA in order that their acceptability can be determined. 4.3 Acceptance criteria for guarantees 4.3.1 To be acceptable in lieu of provisions against country risk, guarantees should meet the following criteria: • they should cover the total exposure to customers of the country concerned after risk transfer; • they should be unconditional and irrevocable. They should also be drafted so that, inter alia, the guarantor will not be released from the obligation by reason of any change in the underlying loan contracts and that the AI will not be estopped from claiming under the guarantee in the event that it reaches a compromise with the borrower; • the guarantors should fulfil their obligations on demand; • there should be proof that the guarantee is issued in accordance with the law of the country in which the parent is incorporated and that the guarantor has complied with all legal requirements for the issue of the guarantee; • the issue of the guarantee should have been approved by a resolution of the Board of Directors of the guarantor and the Board should undertake to notify the AI and the HKMA, should the guarantor's situation change in a way which may

Supervisory Policy Manual CR-G-5 Country Risk Management V.1 – 23.11.01 19 materially and adversely affect its ability to honour the guarantee; • the supervisory authority of the guarantor should be aware of the arrangement and have no objection to it; and • the AI should undertake to disclose the fact that exposures are guaranteed in lieu of provisioning in its annual accounts in Hong Kong. 4.4 Capital adequacy 4.4.1 For the purposes of calculating an AI’s capital adequacy ratio, provisions earmarked against country risk should not be included in its capital base. 5. Disclosure and regulatory reporting 5.1 Disclosure 5.1.1 The HKMA has issued financial disclosure guidelines to both locally and overseas incorporated AIs for the reporting of their cross-border exposures. They should therefore ensure that their management information systems are able to produce the requisite data accurately. 5.1.2 For details of the disclosure requirements, AIs should refer to the following modules: • FD-1 “Financial Disclosure by Locally Incorporated Authorized Institutions”; • FD-2 “Interim Financial Disclosure by Locally Incorporated Authorized Institutions”; and • FD-3 “Financial Disclosure by Overseas Incorporated Authorized Institutions”. 5.2 Regulatory reporting 5.2.1 AIs should establish systems and procedures to ensure the accuracy of reporting in respect of cross-border claims and country risk provisions in the "Return of Cross-Border Claims - MA(BS)9”.

Supervisory Policy Manual CR-G-5 Country Risk Management V.1 – 23.11.01 20 Annex A: Key standards for sound financial systems Standards and Codes Standard-Setting Bodies Macroeconomic policy and data transparency • Code of Good Practices on Transparency in Monetary and Financial Policies IMF • Code of Good Practices on Fiscal Transparency IMF • Special Data Dissemination Standard / General Data Dissemination System IMF Institutional and market infrastructure • Principles and Guidelines for Effective Insolvency and Creditor Rights Systems See Note 1 • Principles of Corporate Governance Organisation for Economic Cooperation and Development • International Accounting Standards International Accounting Standards Board • International Standards on Auditing International Federation of Accountants • Core Principles for Systemically Important Payment Systems Committee on Payment and Settlements • The Forty Recommendations of the Financial Action Task Force on Money Laundering FATF Financial regulation and supervision • Core Principles for Effective Banking Supervision Basel Committee on Banking Supervision • Objectives and Principles of Securities Regulation International Organisation of Securities Commissions • Insurance Core Principles International Association of Insurance Supervisors Note 1: The World Bank is coordinating broad-based efforts to develop principles and guidelines in this area.

Supervisory Policy Manual CR-G-5 Country Risk Management V.1 – 23.11.01 21 ————————— Contents Glossary Home Introduction