HKMA Liquidity Coverage Ratio for Banks: Defining High-Quality Liquid Assets in Hong Kong

The Hong Kong Monetary Authority (HKMA) formally updated its Supervisory Policy Manual (SPM) module on the Liquidity Coverage Ratio (LCR) in late 2024, incorporating the Basel Committee’s revised standards on High-Quality Liquid Assets (HQLA). For banks operating in Hong Kong, the classification of HQLA determines the composition of the liquidity buffer required to survive a 30-day stress scenario. A misclassification—treating a Level 2B asset as Level 1, for example—can trigger a capital add-on or a direct enforcement action under the Banking Ordinance (Cap. 155). The 2025-2026 regulatory cycle sees the HKMA placing greater emphasis on the operational independence of liquidity buffers, meaning that assets pledged as collateral for derivatives or repo transactions cannot be double-counted as HQLA. For compliance officers and treasury teams, the definition of what qualifies as HQLA under the HKMA’s framework is the single most consequential variable in liquidity risk management.

The HKMA’s HQLA Classification Framework

The HKMA applies a three-tier classification system for HQLA, mirroring the Basel III framework with specific Hong Kong modifications. The legislation provides that the LCR must be calculated as the ratio of the stock of HQLA to total net cash outflows over a 30-day stress period. The HKMA’s SPM module CA-G-5, “Liquidity Coverage Ratio,” sets out the specific criteria for each tier.

Level 1 Assets

Level 1 assets receive the highest liquidity value, with no haircut applied under the standard LCR calculation. The legislation defines Level 1 assets as those that can be readily converted into cash at little or no loss of value. For Hong Kong banks, the following qualify:

• Cash and central bank reserves held at the HKMA.
• Marketable securities representing claims on or guaranteed by sovereigns, central banks, or multilateral development banks with a 0% risk weight under the Basel II standardised approach.
• Hong Kong Exchange Fund Bills and Notes, as they carry a zero-risk weight under the Banking (Capital) Rules (Cap. 155L).

The HKMA’s 2024 circular “Liquidity Coverage Ratio and Net Stable Funding Ratio – Treatment of Central Bank Reserves” confirmed that reserves held at the HKMA under the Discount Window are eligible Level 1 assets, provided they are unencumbered. The key operational requirement is that the bank must demonstrate legal and operational control over the assets. The HKMA expects the bank to hold these assets in a separate liquidity portfolio, not commingled with trading inventory.

Level 2A Assets

Level 2A assets are subject to a 15% haircut under the standard LCR calculation. The court procedure is that the HKMA will only recognise Level 2A assets if they meet the minimum price volatility and credit quality thresholds. The legislation provides that Level 2A assets must have a credit rating of AA- or higher from a recognised external credit assessment institution (ECAI).

The specific asset classes include:

• Marketable securities representing claims on or guaranteed by sovereigns, central banks, or multilateral development banks with a 20% risk weight.
• Corporate debt securities rated AA- or higher that are traded in large, deep, and active repo or cash markets.
• Covered bonds rated AA- or higher.

The HKMA’s SPM module CA-G-5 states that the 15% haircut is applied to the market value of the asset. If a bank holds a corporate bond rated AA- with a market value of HKD 100 million, the contribution to the HQLA stock is HKD 85 million. The HKMA does not permit the use of internal ratings for Level 2A classification—only ECAI ratings are acceptable.

Level 2B Assets

Level 2B assets carry a 25% haircut for residential mortgage-backed securities (RMBS) and a 50% haircut for corporate debt securities rated between A+ and BBB- and equities. The legislation provides that Level 2B assets cannot exceed 40% of the total HQLA stock after haircuts. The HKMA applies a strict cap: the total Level 2B assets, after applying the haircut, must not exceed 15% of total HQLA.

The specific asset classes include:

• Corporate debt securities rated between A+ and BBB- that are traded in large, deep, and active markets.
• Common equity shares that are included in a major stock index, such as the Hang Seng Index.
• Residential mortgage-backed securities (RMBS) rated AA or higher, with a maximum loan-to-value ratio of 80% at origination.

The HKMA’s 2023 thematic review on liquidity risk management found that several banks had incorrectly classified equities as Level 2A assets. The HKMA issued a reminder that only common equity shares in a major stock index qualify as Level 2B, and that shares held as collateral for margin lending cannot be included in the HQLA stock.

Operational Requirements and the Unencumbered Condition

The HKMA’s framework imposes an operational condition that is often overlooked by smaller licensed banks. The legislation provides that HQLA must be unencumbered—meaning the asset is not pledged as collateral for any transaction, including derivatives, repos, or securities lending. The HKMA’s SPM module CA-G-5 states that assets used as collateral for central bank facilities, such as the HKMA’s Discount Window, are still considered unencumbered if the bank can demonstrate that the assets are not being used for any other purpose.

The Liquidity Buffer and Operational Independence

The HKMA expects banks to maintain a liquidity buffer that is operationally independent from the day-to-day funding operations. The court procedure is that the buffer must be held in a separate legal entity or a dedicated portfolio that is not subject to any liens or encumbrances. The HKMA’s 2024 circular “Operational Independence of the Liquidity Buffer” clarified that if a bank uses HQLA as collateral for a repo transaction, those assets are immediately disqualified from the HQLA stock until the repo is unwound.

The key practical issue for compliance officers is the treatment of intra-group transactions. If a Hong Kong bank lends HQLA to its parent company, the assets are considered encumbered and must be excluded from the HQLA stock. The HKMA does not permit netting of intra-group exposures for LCR purposes. The bank must demonstrate that the lending transaction is at arm’s length and that the assets are returned within the 30-day stress period.

The Haircut and the Market Value

The HKMA applies the haircut to the market value of the asset, not the book value. The legislation provides that the market value must be determined using a mark-to-market methodology, with the valuation date being the close of business on the reporting date. The HKMA’s SPM module CA-G-5 requires banks to apply a conservative valuation approach, meaning that if a security has multiple market prices, the lowest price must be used.

For Level 2B equities, the haircut is 50% of the market value. If a bank holds HKD 10 million in Hang Seng Index constituent stocks, the contribution to the HQLA stock is HKD 5 million. The HKMA does not permit the use of historical volatility or internal models to reduce the haircut. The haircut is a fixed regulatory parameter.

Reporting and Disclosure Obligations

The HKMA requires banks to report their LCR on a monthly basis, with a detailed breakdown of the HQLA composition. The legislation provides that the LCR must be reported within 15 business days of the end of the reporting month. The HKMA’s SPM module CA-G-5 requires banks to submit a “Liquidity Return” that includes the following:

• The total stock of HQLA, broken down by Level 1, Level 2A, and Level 2B.
• The haircut applied to each asset class.
• The concentration of HQLA by issuer, currency, and maturity.

The HKMA’s 2024 circular “Enhancements to Liquidity Reporting” introduced a requirement for banks to disclose the HQLA composition in their annual Pillar 3 disclosures. The disclosure must include a narrative explanation of any changes in the HQLA composition, such as a shift from Level 1 to Level 2B assets.

The Stress Scenario and the HQLA Assumption

The HKMA’s stress scenario assumes a 30-day period of severe market dislocation. The legislation provides that the HQLA must be available to meet cash outflows without any restriction. The HKMA’s SPM module CA-G-5 requires banks to assume that the HQLA cannot be used as collateral for new funding transactions during the stress period. The bank must demonstrate that the HQLA can be liquidated or used in a repo transaction within 3 business days.

The key assumption is that the HKMA’s Discount Window remains open during the stress period. The HKMA’s 2024 circular “Liquidity Contingency Planning” confirmed that banks can assume access to the Discount Window, but the assets pledged as collateral must be pre-positioned with the HKMA. Pre-positioned assets are considered unencumbered for LCR purposes, provided the bank has not drawn on the facility.

The Penalty for Misclassification

The HKMA has the power to impose a capital add-on under the Banking (Capital) Rules (Cap. 155L) if a bank misclassifies HQLA. The court procedure is that the HKMA will issue a supervisory notice requiring the bank to recalculate its LCR using the correct classification. If the recalculated LCR falls below the minimum 100% threshold, the HKMA can impose a restriction on the bank’s dividend payments or require the bank to raise additional capital.

The HKMA’s 2023 enforcement action against a mid-sized licensed bank serves as an illustration. The bank had classified corporate bonds rated A- as Level 2A assets, when the correct classification was Level 2B. The misclassification resulted in an overstatement of the LCR by 12 percentage points. The HKMA imposed a capital add-on of HKD 800 million and required the bank to submit a remediation plan within 30 days. The bank’s name is not disclosed in the public record.

Actionable Takeaways

• Verify that all assets classified as Level 1 HQLA are unencumbered and held in a separate liquidity portfolio that is operationally independent from trading inventory.
• Apply the correct haircut to Level 2A and Level 2B assets using the market value at the close of business on the reporting date, not the book value.
• Ensure that intra-group lending of HQLA is treated as an encumbrance and excluded from the HQLA stock, unless the lending is at arm’s length and the assets are returned within the 30-day stress period.
• Pre-position assets with the HKMA’s Discount Window to maintain access to central bank liquidity without triggering an encumbrance classification.
• Review the ECAI rating of each Level 2A asset at least quarterly, as a downgrade below AA- reclassifies the asset to Level 2B and triggers a 25% or 50% haircut.

This does not constitute legal advice. Consult a solicitor for your specific case.