WAY FORWARD

89. The package of policy initiatives set out in the foregoing paragraphs will be completed within a period of about three years. As mentioned above, more specific details will need to be worked out in order to implement the individual initiatives. The HKMA will ensure that the banking industry, as well as the general public interested in the future development of the Hong Kong banking sector, will be kept informed of, and where appropriate, consulted on the implementation of these initiatives.

Hong Kong Monetary Authority

Annex 1

Timetable for Implementing the HKMA’s Package of Policy Initiatives

Review

Clarify the HKMA’s role as lender of last resort

Allow RLBs access to RTGS system

Relax the one building condition to allow three branches for foreign banks.

Begin monitoring process prior to the start of deregulation of IRRs.

Phase 1 deregulation of the IRRs (time deposits up to 6 days).

Phase 2 deregulation of IRRs (all remaining interest rate caps).

Enhancing the role of the board of directors

Study and consultation on establishing a

Relax time period and association with Hong Kong entry criteria.

Improved risk-based supervisory regime

–Long term deregulation is inevitable and desirable –Deregulation should be postponed until all indicators are favourable

–Queries whether the concerns regarding impact of deregulation on stability are overstated –Recommends full deregulation as soon as possible –Important to have a transparent decision process and monitoring indicators should be made known to the public –Further deregulation will pressurise small and medium sized banks into taking higher risk and is undesirable

–Support phased deregulation to promote competition and innovation in the banking market

–IRRs should be abolished immediately–The larger banks consider it undesirable to eliminate the IRRs in 1999 but once it is appropriate to start the process, it could be accelerated so that the final phase is implemented before the 2002 date suggested in the Study –The smaller banks hold different views on this issue. One local bank considers it destabilising to deregulate the remaining IRRs while another bank considers that decisions relating to the level of interest rates should not be in the hands of HKAB which may be influenced by the commercial interests of its members –The policy has outlived its usefulness and could be removed without undue competition from foreign bank branches –However, with relaxation of market entry criteria and less demanding disclosure requirements for foreign banks, it may tilt further the playing field against local institutions

–As only a limited number of institutions would increase their branch network, there is little threat to instability if this policy is removed –Eventually there should be no need for a cap on the number of branches –Relaxation would cause undue hardship to small and medium sized banks

–Supports phased relaxation of this policy to promote a more competitive market –Supports full liberalisation immediately

–A large bank noted that the policy is inconsistent with the desire for open markets –A small bank noted that further relaxation would only cause hardship to the small and medium sized local banks and instability to the sector at a time of crisis

Anne x 2

–Some banks found the arguments to allow access by RLB/DTCs to the system to be weak and RLB/DTCs will gain an unfair competitive edge over banks for payment business given their lower cost of entry –But if system is to be opened up, RLBs and DTCs should be prepared to pay for the service –Strongly supports this recommendation and urges that this be implemented quickly –RLBs involved in debt securities underwriting and foreign exchange trading would have a strong business need for access to RTGS

–Supports in principle the recommendation that access to the system be reviewed in conjunction with a change towards a two-tier licensing structure –More appropriate means of defining access criteria should be considered –Disagree with this recommendation as the current system is functioning properly

–Suggest that the system be opened to all qualified participants to allow fair competition to take place –The licensing system should not be the sole criterion for access to RTGS

–A small bank considers that the current arrangements are working well and there is no need for change –A large bank agrees that a more appropriate means of defining access should be considered Clarifying the HKMA’s role as lender of last resort –Not against clarification but the HKMA would still need to maintain flexibility to deal with abrupt changes and take timely actions –HKMA’s role as lender of last resort could conflict with its position as a defender of the currency peg

–Supports clarification–Supports clarification –But HKMA must improve transparency in the exercise of its discretionary power –Public awareness should be enhanced about the fact that there is no assurance that an insolvent bank will necessarily be rescued –Supports clarification –HKMA should increase transparency of its policies and operations

–Supports clarification–No comment–A small bank agrees with the recommendation to formalise and clarify HKMA’s role as lender of last resort

HKABDTCAConsumer CouncilChinese ChamberChinese Manufacturers’Hong Kong Democratic6 Banks of CommerceAssociationFoundation(3 Local & 3 Foreign) Allowing access to the RTGS system by RLBs/DTCs

–Recognises the need to accommodate smaller financial institutions with a tiered approach –Opposed to the recommendation that the restriction on the provision of checking accounts be maintained –Advocates that the future second tier of AIs should be allowed to take deposits of $100,000 and above and with no maturity restriction –Concern that increasing the minimum deposit requirement will lead to more DTCs choosing to revoke their authorisation and becoming unregulated –Agrees with the need for consolidation of the tiered system –Considers it appropriate to retain a distinction between banks and RLBs to protect smaller depositors –Concern that some DTCs may not opt to upgrade their licences and become unregulated entities

–The existing system is functioning properly and customers have no complaints about it and therefore suggests that the status quo be maintained –Agrees that the current system could be simplified into a two-tier system given the insignificant market share of RLBs and DTCs –Supports the simplification of the current system but wonders whether a unitary licensing system would be sufficient

–A small bank disagrees and believes that the current three-tier system should be maintained –Two large banks agree with restructuring the sector into two tiers equirement for local AIs –Supports an upward adjustment of minimum capital requirements for local AIs –But foreign branches should also be subject to some kind of minimum asset or minimum branch capital requirements

–No specific comment–Supports this recommendation and agrees that capital requirement for local institutions should be consistent with international standards but should into account the ability of small and medium sized banks to meet such requirements –No specific comment–No specific comment–A small bank believes that branches of foreign banks should be subject to the same minimum capital requirements

DTCAConsumer CouncilChinese ChamberChinese Manufacturers’Hong Kong Democratic6 Banks of CommerceAssociationFoundation(3 Local & 3 Foreign)

–Nearly all responses from members were against the introduction of a deposit insurance scheme –Considers deposit insurance to be a fire- fighting rather than a preventive measure –Appreciates that the HKMA may see a need to enhance depositor protection in view of international developments –Any scheme proposed must be voluntary on the part of depositors and banks –Supports the commissioning of a detailed study by HKMA on alternative forms of protection to deposit insurance –Considers the existing priority payment scheme for small depositors to be of limited use –A more explicit government-sponsored deposit insurance scheme would be much more effective in raising consumer confidence –Establishment of a deposit insurance scheme should be given priority –There are measures to mitigate the moral hazard problem associated with deposit insurance (e.g. setting insurance premium based on risk levels of individual institutions) –Welcomes the proposed study on a depositor protection scheme –The proposal to enhance the existing priority payment scheme deserves merit –Supports the proposal to require foreign bank branches to maintain sufficient assets in Hong Kong to meet priority payment obligations under the Companies Ordinance

–Holds neutral views on this issue –Considers a move in the direction to enhance depositor protection to be correct –Deposit insurance raises the issue of moral hazard and costs would be borne by consumers, particularly commercial customers –HKMA should carefully study other forms of depositor protection –Provision of deposit insurance can actually be more destabilising since it raises the risk of moral hazard –No need to revisit this issue, which was concluded in 1992

–The large banks comment that any such scheme should be targeted where depositor protection is most needed and should be voluntary. The largest banks, measured by size or credit rating, should be exempt from any scheme. –The smaller banks consider that the absence of deposit insurance benefits larger banks more and believe that there should be an explicit depositor protection scheme. Relaxing the time period and association with Hong Kong entry criteria –There are diverse views between foreign and local banks on these issues but the recommendations broadly appear to strike the right balance –HKMA should carefully assess the impact before any changes take place –The proposed reduction of the period of association with Hong Kong to three years appears to be too short

–Foreign bank entry to Hong Kong should not be too stringent –The time period and association with Hong Kong criteria could be relaxed for qualified institutions –Shares the consultants’ views that the criteria appear overly burdensome and unnecessarily restrictive

–Disagrees with the recommendation as Hong Kong already allows easy entry for foreign banks and this might intensify unhealthy competition between small and medium sized local banks and foreign banks –Suggests that the time period criteria be shortened to 5 years instead of 3 to allow the HKMA more time to assess the business and reputation of the institutions concerned –No specific comment–A small local bank disagrees with relaxing the criteria as the playing field is already biased towards foreign banks

HKABDTCAConsumer CouncilChinese ChamberChinese Manufacturers’Hong Kong Democratic6 Banks of CommerceAssociationFoundation(3 Local & 3 Foreign) Conducting a study on enhancing depositor protection

–Improved financial disclosure is essential in safeguarding the banking system –Fuller disclosure by foreign banks particularly those with a large share of retail business would be fair and not burdensome –Supports the HKMA’s move to close the transparency gap that presently exists between local and foreign banks –Emphasises the need to ensure that any local branch information be placed within the overall context of the financial strength of the whole institution –Supports the recommendation that foreign banks should disclose more financial information consistent with that provided by local banks

–Supports the recommendation to improve disclosure for all institutions

–No specific comment–Two small banks favour greater disclosure of financial information of foreign banks –One foreign bank contends that the financial disclosure of a branch must be made in the right context with reference to the position of the whole institution visory approach –No specific comment–No specific comment–No specific comment–Agrees that the direction towards risk-based supervision is correct –Suggests that HKMA reviews the risks facing the financial and banking systems, promote the concept of risk-based supervision to staff responsible for bank supervision and the banking sector and assess the impact of the Mainland economy on the local banking sector –No specific comment–Two large banks comment that the risk- based approach must not result in any increase in the already heavy reporting burden on banks –A foreign bank encourages the HKMA to increase transparency in its supervisory process

DTCAConsumer CouncilChinese ChamberChinese Manufacturers’Hong Kong Democratic6 Banks of CommerceAssociationFoundation(3 Local & 3 Foreign) e by foreign bank branches

Annex 3

Specific Criteria for Monitoring Indicators 1. Two consecutive quarters of real GDP growth

As a result of the Asian financial crisis, the Hong Kong economy has recorded negative real GDP growth for five consecutive quarters (Q1/1998 to Q1/1999). This indicates that the economy is still in a recession and the operating environment for the banking sector remains difficult. Deregulating interest rate rules in such an environment is likely to increase systemic risk for the banking sector.

The HKMA believes that deregulation should be carried out in a stable economic environment in order to avoid compromising the stability of the sector. Two consecutive quarters of positive real GDP growth would generally indicate that the economy is in the process of recovery and the environment is likely to be more favourable for deregulation to take place.

2. Differential between HIBOR and US$ LIBOR has stabilised and is close to the pre-crisis levels

The interest rate differential between Hong Kong dollar interest rates (i.e. HIBOR) and United States dollar rates (i.e. US$ LIBOR) is the premium demanded by the market for holding Hong Kong dollars. It is indicative of market confidence in the Hong Kong dollar.

A high and volatile differential between HIBOR and US$ LIBOR is indicative of fragile market sentiment. Such an environment would be less suitable for interest rate deregulation to take place.

3. Capital adequacy ratio of the banking sector remains at traditionally high levels

The capital adequacy ratio (CAR) is the ratio of an authorised institution’s capital base to its risk-weighted credit exposures. It is an internationally accepted standard for measuring a financial institution’s capital strength.

At present, the average CAR of locally incorporated authorised institutions is around 18%

and this has been fairly stable over the last few years. The maintenance of the ratio at traditionally high levels provides assurance that the banking sector would be able to cope with the possible negative impacts on their financial condition as a result of deregulation.

4. Signs of improvement in the classified loans ratio for the sector

Authorised institutions are presently required to classify their loans and advances into five categories, namely Pass, Special Mention, Substandard, Doubtful and Loss. The classified loans ratio is the ratio of loans classified as Substandard or below to total loans outstanding.

An increase in this ratio indicates deteriorating asset quality.

Since the Asian financial crisis, asset quality of the sector has continued to deteriorate. The classified loans ratio reached a high of 8.82% in the first quarter of 1999. Rapidly deteriorating asset quality has an adverse impact on both the profitability and the capital strength of banks and makes the system as a whole more vulnerable to adverse and unstable conditions. Lack of improvement in the classified loans ratio would therefore raise the question of whether deregulation should proceed.

5. Absence of significant narrowing of net interest margins of the banking sector similar to that experienced during the period of the Asian crisis (i.e., 4Q 1997 to 3Q 1998)

The HKMA considers that continued significant deterioration in net interest margins such as that experienced by the local banks in 1998 (a fall from 2.44% to 2.26% in relation to business in Hong Kong) would provide a warning sign that it might be safer not to proceed with deregulation.

6. Absence of severe strains on the profitability of a significant proportion of the local banking sector

To some extent, this follows from the two previous criteria. If profitability of a significant number of banks remained under severe stress (and in particular if some banks were recording losses), it would be sensible to delay deregulation so as not to increase these financial strains.

Annex 4

Policy Statement on the Role of the Hong Kong Monetary Authority