Hong Kong Banking Sector Consultancy Study: Hong Kong Banking into the New Millennium

The Hong Kong Monetary Authority (HKMA) released today (18 December) the findings and recommendations of a consultancy study on the strategic outlook of the Hong Kong banking sector over the next five years.

"This is the culmination of work performed by the consultants (KPMG and Barents Group LLC) over a period of nine months. The objective of the study is to assist the HKMA in developing an appropriate strategy to develop the regulatory and supervisory framework in response to market developments over the next five years," said Mr David Carse, Deputy Chief Executive of the HKMA. "The recommendations contained in the report are those of the consultants. Neither the Exchange Fund Advisory Committee nor the HKMA has taken a view on the recommendations." Mr Carse added.

The study's assessment of the local banking sector highlights a number of positive features which have contributed to the development of Hong Kong as one of the world's major banking centres. These include a well developed financial infrastructure, a conducive regulatory environment and sound supervisory process, free and open markets, a modern and effective legal system and a high degree of transparency. Within this setting the sector has been able to maintain high safety and soundness standards and impressive financial performance which compares favourably to international standards, particularly in terms of efficiency and asset quality.

The study identifies a number of global forces and trends in financial services which will shape the development of the Hong Kong banking sector. The end-result is likely to be increased competition and more efficient behaviour in the banking sector. However, the trends will also introduce a number of new challenges and increase overall complexity and the level of risks to which banks and the sector will be exposed.

Accordingly, the consultants have produced a package of recommendations aimed at enhancing the level of competitiveness of the Hong Kong banking market as well as strengthening the safety and soundness of the banking sector as a whole so that the benefits of increased competition and greater efficiency can be fully realised. In this regard, the consultants have made recommendations on certain regulatory features of the banking system and the HKMA's supervisory approach to ensure that they remain appropriate for the evolving financial markets. The supervisory recommendations are intended to take forward the HKMA's transition to a more "risk-based" approach in its supervision. The main recommendations include the following:

Regulatory features of the banking system

• Partial relaxation of the one-branch policy currently applicable to most foreign banks;
• Continued improvements to financial disclosure;
• Relaxation of market entry criteria;
• Simplification of the three-tier system;
• Study to enhance depositor protection; and
• Phased deregulation of the remaining interest rate rules.

Recommendations to enhance the supervisory approach of the HKMA

• Formalisation of a strategic planning process for banking supervision; Development of a formal risk assessment framework and quality assurance programme;
• Greater integration of risk management principles into supervisory activities;
• Formalisation of career development and enhancement of training needs;
• Creation of additional specialist teams; and
• Enhancement of the supervisory database and information systems

The consultants consider that the two sets of recommendations, both regulatory and supervisory, would be best implemented in parallel using a phased approach. The consultants have suggested a "road map" for change, covering a period of several years.

Welcoming completion of the consultancy report, Mr Carse noted that "Global banking is becoming more competitive and complex. As a major banking centre, Hong Kong will inevitably be affected by these trends. In the long run, an enhanced level of competition will serve to strengthen the banking sector as a whole and promote Hong Kong*s position as a leading international financial centre."

"However at the same time, we are well aware that changes to enhance competition and efficiency in the banking system must be balanced by the need to maintain a stable environment. Accordingly, measures aimed at liberalising the market and promoting competition should be considered in parallel with measures to enhance the safety and soundness of the system. The consultants' report provides a coherent framework within which this process can be carried forward."

Mr Carse added that "each of the proposals for change recommended by the consultants will need to be carefully considered by the Government and the HKMA. Full consultation on the proposals of the consultants will take place with all relevant parties before any of the proposed changes are implemented."

It is intended to publish full details of the consultants' recommendations in the near future, to be followed by a three-month consultation period.

Hong Kong Monetary Authority
18 December 1998

INFORMATION NOTE

The Hong Kong Banking Sector Consultancy Study:
Hong Kong Banking into the New Millennium

Background

1. At the beginning of this year, the Hong Kong Monetary Authority ("HKMA") commissioned a consultancy study on the future development of the Hong Kong banking sector ("the Study"). The main objective of the Study was to evaluate the strategic outlook for the banking sector in Hong Kong over the next 5 years and to consider the effectiveness of the HKMA's approach to banking supervision. KPMG and Barents were subsequently appointed as the consultants to carry out the Study which commenced in March 1998.

2. The consultants have now completed the Study and produced a report which contains their findings and recommendations for changes to be made to some of the existing regulatory features as well as steps to advance the HKMA's supervisory regime. The main findings and recommendations of the consultants are contained in the attached Executive Summary (Chapter 1) of the Final Report of the consultants and a brief summary of these is given below.

3. The recommendations contained in the Report are those of the consultants. Neither the Exchange Fund Advisory Committee nor the HKMA has taken a view on the recommendations.

The Consultants' Overall Assessment

4. The consultants consider that Hong Kong has a sound, safe and dynamic banking sector. Overall, Hong Kong banks compare favourably with international standards in terms of profitability, efficiency and transparency. The supporting banking sector infrastructure compares favourably by all measures with other countries that were benchmarked. The key success factors include -

• a well developed financial infrastructure;
• a conducive regulatory environment and sound supervisory process (reflecting internationally accepted principles);
• a free and open market;
• a modern and effective legal system; and
• a high degree of transparency.

Within this environment, the Hong Kong banking sector has been able to grow and maintain high safety and soundness standards.

An Evolving Banking Sector

5. The consultants identify a number of global forces and trends in financial services which will shape the development of the Hong Kong banking sector. The end-result is likely to be increased competition leading to advances in efficiency, innovation and customer service. At the same time, the global trends will introduce a number of new challenges and increase overall complexity and the level of risk to which banks and the sector will be exposed. Therefore the challenge for Hong Kong lies in how to exploit future opportunities while containing the risks.

Four Suggested Strategic Mandates for HKMA

6. Given the new emerging environment, the consultants have suggested four strategic mandates for the HKMA:

• Regulatory and supervisory framework - to ensure that the regulatory and supervisory framework for Hong Kong remains appropriate for the evolving financial markets.
• Development of a competitive banking sector - to improve the competitive environment to ensure the positive benefits of global and local trends are developed in the Hong Kong market, and Hong Kong remains an attractive international financial centre.
• Safety and stability of the banking system - to ensure increasing levels of risk associated with global and local trends are prudently managed and that Hong Kong's exposure to systemic risk is mitigated.
• Efficiency and integrity of the financial system - to increase the level of transparency, both within the banking sector and across financial and capital markets, to allow the forces of market discipline to work more effectively.

The Consultants' Main Recommendations

7. The consultants have made a number of recommendations in pursuit of these mandates. The overall package aims to improve the competitiveness of the Hong Kong banking market as well as to enhance the safety and soundness of the banking system as a whole. The consultants consider that this is a coherent package of proposals which should be introduced in parallel, using a phased approach. This takes into account the fact that opening up the market to increased competition in order to strengthen local banks' ability to compete will, at the same time, require improved supervisory processes to ensure that the banks are capable of dealing with such an environment.

(i) Phase 1 - enhanced risk-based supervision (1999)

The focus of Phase 1 is to enhance the HKMA's supervisory approach, to better position the HKMA to address the risks and increased competition within the market place, prior to substantive changes to the regulatory system. The consultants have also recommended that the HKMA initiate the process towards a more competitive sector by relaxing the one branch policy to allow foreign banks to operate up to a maximum of three branches. The expected difficult operating environment in 1999 would likely prevent further deregulation of interest rate rules ("IRR") during Phase 1. However, a programme to monitor key stability indicators should be undertaken during this phase in preparation for deregulation to take place during the second phase.

(ii) Phase 2 - market restructuring (2000 to mid 2001)

During Phase 2, the emphasis would shift from the supervisory approach towards implementing a revised market structure, although implementation of the recommendations in the enhanced supervisory approach would continue. The consultants recommend that the HKMA raise the minimum level of capital required for local institutions and begin a study to enhance depositor protection. Both are intended to enhance the safety and stability of the sector. Competitiveness would be further enhanced through measures such as simplifying the three-tier licensing system and implementing the first two stages of interest rate deregulation (subject to continued monitoring of stability indicators).

(iii) Phase 3 market liberalisation (mid 2001 to end 2002)

Phase 3 deals with the recommendations concerning the remaining barriers to a free and open market. These should be implemented once the improved supervisory approach is in place and the market structure is revised. Should the study concerning the need for enhancing explicit depositor protection (to be completed during Phase 2) requires changes to existing arrangements (e.g. the introduction of deposit insurance or other forms of enhanced protection schemes), then it would be appropriate to begin implementation of this prior to further liberalisation of the market. The final stage of interest rate deregulation would take place during this period.

8. The key recommendations to be implemented in each phase are summarised in the attached table.

Way Forward

9. The recommendations in the report will need to be carefully considered by the Government and the HKMA. In doing so, views will be sought from all interested parties. There will be full public consultation on the proposals of the consultants. It is intended that the consultation period should last for three-months.

10. The HKMA will also brief the LegCo Panel on Financial Affairs, the Banking Advisory Committee and the Deposit-taking Companies Advisory Committee on the recommendations in the consultancy report.