For discussion
On 1 February 1999

INTRODUCTION

1. At the beginning of 1998, 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 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.

3. A 155-page document containing the full details of the recommendations (copy at Annex 1) was recently released to the public for consultation with interested parties which will last until the end of March 1999. The Executive Summary of this report had earlier been forwarded to Members.

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.

AN EVOLVING BANKING SECTOR

5. The consultants identified 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 consultants consider that 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.

8. The recommendations in respect of the changes to some of the current regulatory features were arrived at after consideration of the original rationale for these policies, assessment of their strengths and weaknesses in the current banking environment, views from market participants and their continuing relevance in the future banking environment. The consultants have also compared these regulations with developments in other countries to gauge whether Hong Kong's regulatory environment was in line with other international financial centres. A table summarising this comparison is at Annex 2.

(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 paid-up 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) recommend 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.

9. The key recommendations to be implemented in each phase are summarised in the attached table at Annex 3.

WAY FORWARD

10. 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. The public consultation exercise will last until the end of March 1999.


Hong Kong Monetary Authority
January 1999

Annex 2

Comparison of certain regulatory features between Hong Kong and selected international financial centres

Annex 3