HONG Kong banks will be consulted soon on how best to implement bilateral netting arrangements which could reduce banks' capital requirement for trading in off-balance sheet activities such as foreign exchange and interest rate-related transactions. Recognising the netting method will lead to the calculation of the risk weighting on the net amount rather than the gross claims arising out of transactions with the same counter-parties. Deputy chief executive (banking) of the Hong Kong Monetary Authority David Carse said a consultation paper would be issued soon to the banking industry asking banks to seek their own legal advice if they want to implement netting. Opinions sought from the Hong Kong Law Society had confirmed that Hong Kong laws were sympathetic to netting. ''We may set out conditions whereby we will allow bilateral netting; some ground rules for banks to observe,'' Mr Carse said. It will then be up to the banks to draw up their contractual agreements with each other on netting. He expected to see the arrangement recognised by the end of this year. Banks would no doubt welcome the move because that would reduce the capital requirement and subsequently lower the cost of such transactions. The Basle Committee on Banking Supervision conducted a general consultation on the subject last year. It was then concluded, after receiving comments from other bank supervisors, that ''the primary burden rests on banks to demonstrate to their supervisors the legal enforceability of netting arrangements in all relevant jurisdictions''. By recognising netting, the committee had proceeded to make amendments to the Capital Accord issued in July 1988 which prescribed the capital requirement of banks on their credit risk exposure. In addition, the committee suggested a formula to recognise netting effects in the calculation of add-ons for potential future exposure. Because of uncertainties in market movements, credit risk of certain instruments increases over time. As a result, banks have to put up additional capital which is calculated by using a formula applied on the gross notional amounts. The add-on factor depends largely on the maturity and volatility of the instruments concerned. The longer the maturity, the higher the volatility, the higher would be the add-on, and more additional capital should be provided. It is proposed by the international committee that if netting is allowed, it would make sense to adjust accordingly the add-on factor based on the net amount, instead of the gross amount. Consultation has just begun on the calculation of an alternative add-on formula for recognising the netting effect. ''In most institutions, it would result in a reduction of capital adequacy,'' said Mr Carse, adding that an individual institution's business mix was the deciding factor. Foreign exchange and interest rate-related contracts would mainly benefit from a lower capital requirement. But on the other hand, the introduction of a more conservative add-on to other derivatives with longer-term contracts exposed to more volatile markets would result in more capital needed as back-up. To ensure there was no delay in the implementation of netting, Hong Kong would proceed with consultations about proper legal documentation to accommodate netting while remaining vigilant in monitoring further developments brought about by the add-on element. ''Derivatives are not a big part of the local banks' business so far,'' said Mr Carse. The reason was that Hong Kong did not have a well-developed capital market, the foundation for instruments such as derivatives. The concern was how the business would grow in future, Mr Carse said.