OREANDA-NEWS. Fitch views the introduction of a 2.5% countercyclical capital buffer by the Hong Kong Monetary Authority (HKMA) - phased in over a four-year horizon from 2016 - as accommodative, given the territory's high leverage and buoyant property market. Hong Kong has been classified as '3' - high - since November 2010 in Fitch Ratings' macro-prudential indicator scale which we use to identify potential systemic stress.

A potentially significant source of vulnerability for Hong Kong banks is the rapid increase in China-related exposures in the last few years, and the uncertainty associated with the macroeconomic slowdown in China and the cross-border enforceability of mainland collateral.

The HKMA may yet accelerate the transition for implementing the full 2.5% capital buffer following further consultation, thereby deviating from the Basel-recommended phase-in timeline of 0.625% per annum from 2016-2019. However, we consider it unlikely that HKMA would set a buffer exceeding the upper threshold of 2.5%, even though this could be justified by the underlying data.

Hong Kong's aggregate private sector credit to GDP, with credit measured in terms of loans and advances extended by institutions' Hong Kong offices excluding those for use outside of Hong Kong, significantly exceeds the ratio's long-term trend. The latest data from the HKMA shows the deviation from trend at 33 percentage points. Notably, a buffer requirement of 2.5% maps to a credit/GDP gap of 10 percentage points as per the Basel committee's indicative guide.

This announcement adds some clarity, though transparency on bank-specific fully-loaded capital requirements remains limited in contrast with other developed markets. We expect banks' end-point common equity Tier 1 (CET1) minimum ratios to range between 11.5% and 13.0%. Our estimate is based on capital conservation and countercyclical buffers set at 2.5% each, additional bank-specific loss-absorbency requirements of 1%-2.5% for domestic systemic importance (expected to be set in 1Q15), and a 1%-1.5% bank-specific Pillar 2 requirement as per HKMA's discretion.

Under this scenario, at least two Hong Kong-incorporated banks - China Citic Bank International and Industrial and Commercial Bank of China (Asia) - would need to build up more capital during the transition period.

Uncertainty remains over whether banks will be able to use their regulatory reserves - which are currently set aside as a "Pillar 2" loss-absorption buffer as required by the HKMA - to meet these capital requirements. If the regulatory reserve is not allowed, most Fitch-rated banks would require additional capital to meet the expected end-point ratio.

The monetary authority's framework for determining the countercyclical buffer takes into account current property market conditions and leverage in the economy as their starting point for determining the countercyclical buffer level. High credit growth rates and high real estate prices relative to long-term trends were particularly highlighted by the HKMA as rationales for potentially increasing the countercyclical buffer further beyond 2016. Banks' average CET1 and total capital ratios were 13.5% and 16.4%, respectively, as of end-September 2014.