Regulatory risk and strategic controls of financial institutions:
institutional dynamics in an emerged global financial centre
Artie W. Ng
The Hong Kong Polytechnic University
Abstract
Prior studies have revealed the interdependency among corporate governance, risk
management and management controls in organizations. Such interdependency is
considered inevitable within a public sector driven by pertinent policies and
regulations. Harnessing a literature review on risk management and management
controls pertinent to financial regulations, this study adopts a longitudinal case study
to reveal the evolution of strategic controls for financial institutions in an emerged
global financial centre. Examining the role of policy in defining regulatory objectives
and the development of a specialized institution model dominated by two main
financial regulators, it looks into the vulnerability of such financial supervision
architecture that instigates unprecedented financial innovation to externalities.
Mitigations to such regulatory risk through precautionary measures and strategic
controls among the regulated are deliberated. This paper argues that the dynamics
between the regulators and the regulated over the increased risk controls are
contingent to the externalities of unprecedented systemic risk and resulting control
failures. Such increased risk controls are reflected through institutional isomorphism
among the regulated financial institutions trailing legitimacy. An underlying
institutional dynamic risk management model seeking an optimum within the
established financial supervision architecture is grounded.
Keywords Risk management, Regulatory risk, Financial institutions, Strategic control,
Institutional dynamics
1.
Introduction
In the recent years, Hong Kong Special Administrative Region of China (Hong Kong)
has been viewed as an emerged global financial centre in Asia for a number of its
inherent strengths. As articulated by Leung and Unteroberdoerster (2008), Hong
Kong possesses the “first-mover” advantage as China’s financial system would
continue to integrate with the rest of the world. With a well-functioning legal and
financial regulatory system, Hong Kong has also been a platform for capital raising
and facilitating cross-border financial transactions. Despite Hong Kong’s past
success, Leung and Unteroberdoerster (2008) noted, “it (Hong Kong) would require
maintaining its competitive edge on skills, legal and institutional infrastructure, as
well as regulation, thereby creating an environment that promotes both stability and
innovation”.
Nevertheless, the collapse of Lehman Brothers in the U.S. (LB) had a significant
impact to the financial regulatory system of Hong Kong as the local investors of LB
“Minibond”1 incurred severe losses and censured the effectiveness and accountability
1
According to HKMA (2008), Minibonds are credit-linked notes, arranged by Lehman Brothers Asia
Limited, with payment of interest and redemption payout at maturity linked to the credit of specified
1
of the two major regulators: Hong Kong Monetary Authority (HKMA) and the
Securities and Futures Commission (SFC). Although both HKMA and SFC have
conducted reviews about strengthening their effectiveness through reform of the
current supervision architecture into an integrated or a “twin-peak” approach (HKMA,
2008; SFC, 2008), there are still concerns over such reform in dealing with systemic
risk effectively.
Through revealing the case of Hong Kong’s financial institutions impacted by global
systemic risk, this paper intends to reveal the underlying regulatory risk controls
seemingly reemphasized and implemented in an optimal manner under the unique
organic developmental experience of Hong Kong’s financial regulatory system.
Through this case study, it provides evidence about dynamics among policy
objectives, the regulators and the regulated as institutions in response to the
externalities of unprecedented systemic risk and resulting control failures. Such
responses are formulated as an array of risk control measures embraced by the overall
strategic objectives in financial regulation embedded in financial supervision
architecture. Such increased risk controls are demonstrated as institutional
isomorphism among the regulated financial institutions contingent to adverse impacts
by a global financial crisis.
2.
Growing Concerns over Global Financial Regulations
Under the global financial system, there have been concerns over the growing
systemic risk across the borders and suggestions for a global regulatory system to
tackle such risk. As pointed out by D’Apice and Ferri (2010), financial instability
could be traced back to the 1930s but had become increasingly widespread in the past
25 years in different forms of bailout. The problem of systemic risk became a
significant concern among public policy makers, bank regulators and central banks
since the Asian financial crisis in 1998 as well as the Russian and Latin American
crises in the 1990s (Alexander et al., 2006). Furthermore, Davis and Green (2008)
pointed out that there could be emerging turbulence in the financial market given the
interconnectedness among the markets; however, the existing international regulatory
system is rather pathetic and lacks strong mechanisms of crisis management. It was
noted that the highly diversified investment banking groups, hedge funds and other
innovative initiatives in the capital markers had also complicated the regulatory
environment (Davis and Green, 2008).
As a result, there are advocates for strengthening the global regulatory framework in
order to regulate these increasing cross-border financial activities more effectively.
Such proposed reform could build on the emerging International Financial Reporting
Standards, Basel Standards and Financial Stability Forum (now Financial Stability
Board), etc. For instance, Basel II and then Basel III standards being adopted by
various regulators of the world have been viewed as initiatives that could enhance but
also complicate the role of risk management within international banks (Wahstrom,
2009).
reference entities (which are generally well-known companies) for each series of Minibonds.
Minibonds are subject to certain types of early redemption event. The interest coupon varied from
series to series but was, generally, comfortably above the prevailing HIBOR/LIBOR at the time of
issue.
2
Despite the insight about the need to strengthen the cross-border regulations, there are
practical concerns over the implementation given the variations in legal and political
systems among the countries of the world. In the first instance, there are currently
various regulatory structures across the world. As studied by Pellegrina and
Masciandaro (2008), both the politicians and the central bank in a country would have
a significant role to play in the shape of financial supervision architectures
domestically. It was explained that a country would have a single authority,
specialized model or a hybrid model of supervision architecture; for instance, a
unified model could be associated with good governance, judicial efficiency and the
absence of corruption. The study suggested that it would be rather unrealistic to
pursue the optimal supervision architecture through a simple traditional cost-benefit
analysis as there were political factors within each country (Pellegrina and
Masciandaro, 2008). As a result of these local issues, there are differences in
supervision architecture as well as strengths and weaknesses among these different
architectures in dealing with regulatory risks.
3.
Neo-Institutionalism
3.1
Institutional Isomorphism
To study the dynamics of the financial institutions involved in the regulations, there is
growingly perceived relevance of institutional theory. In particular, neoinstitutionalism notes that institutions are typically influenced by the broader
environment in which their main goal is to survive. DiMaggio and Powell (1983)
pointed out that institutions need to establish political power and legitimacy and that
such institutional effects are diffused throughout organizations by coercive
(constraining), mimetic (cloning), and normative (learning) mechanisms.
Isomorphism of institution was described as a constraining process that forces one to
resemble another unit facing similar environmental conditions but not necessarily to
become more efficient. Such three types of institutional forces are found to be more
significant to governmental organizations than organizations in the business and nonprofit sectors (Frumkin, 2004).
3.2
Financial Regulations and Institutions
In examining the globalization of financial markets, Carruthers et al (2001) unveiled
that there had been widespread deregulation and globalization of capital markets
where formerly regulated financial markets were then unrestrained. Looking into the
development of central banks and bankruptcy law, the study suggested that
international convergence in regulations was occurring among nations but divergence
in practice took place among institutions in different countries.
On the other hand, Merton and Bodie (2005) argued that neoclassical theories
provided limited prescription for the institutional structure of financial systems and
therefore incomplete guidance to decision makers seeking to understand and manage
the process of institutional change. Specific kinds of financial intermediaries, markets,
and regulatory bodies would evolve in response to underlying changes in technology,
politics, demographics, and cultural norms under the continuing innovation in
financial firms. An analytical framework that treats functions rather than institutions
as the conceptual anchors would enhance study about the dynamics of financial systems.
3
The study also noted that emerging countries such as China might need to undertake
restructuring of their financial systems in order to sustain their economic growth
(Merton and Bodie, 2005).
In a more recent study about the role of institutions in facilitating economic
development and growth of state, Fligstein and Choo (2005) pointed out that
institutional components of national corporate governance would work together as a
system, including institutional features of property law, financial market regulation
and labor law. Accordingly, importation of another country’s corporate governance
institutions could hardly work without an integrative system in place. Fligstein and
Choo (2005, p.79) also suggested that it would be unrealistic to have a single model
for different jurisdictions and explained paths for such studies, "First, we think that
comparative studies in institutions and economic growth must be analyzed
longitudinally within countries, as they evolve over time. Linking institutions,
institutional change, and economic growth together more carefully in some societies
might reveal more closely when and why institutions matter. Such research will also
begin to untangle the kinds of feedback that are possible between institutions and
economic actors. As societies develop and new interest groups appear, for example,
such developments may alter institutions. We also know that institutions that exist set
up the possibilities for new institutions. It seems useful to tease out such trends and
dynamics over long historical periods.”
4.
Risk Management and Strategic Controls
4.1
Wide awake of the financial tsunami
The financial crises as explained by D’Apice and Ferri (2010) were intertwined with a
series of dynamic processes influenced by the “mechanisms of the capitalist
economy”, which might lead to financial instability if not regulated effectively. In
their study, the model about financial instability by Minsky (1975) was adopted to
illustrate the irrational exuberances within the financial sector caused by economic
expansion and contraction over a period of time. With the ongoing issues with global
financial crisis, there are increasing concerns among the public over the adverse
impacts caused by the financial institutions which are expected to be regulated
effectively. Middaugh (1988) pointed out that new management control systems were
needed for the financial services industry that were changing fast under the on-going
consolidation and deregulation of the industry. The regulators would in fact need to
bear the fiduciary duty to be accountable for managing risk associated with regulatory
failures.
Risk management would particularly be critical for public sector organizations which
are accountable to a broad range of external stakeholders (Ng and Mitchell, 2009;
Woods, 2009). A balance between performance and risk management needs to be
maintained for an organization’s sustainable development in consideration of its
strategic objectives. Carbo (2010) pointed out the challenge in balancing financial
innovation and regulation in the case of Spain after the financial crisis of 2008,
“Effective regulation of systemic risk is that which achieves a balance between
maintaining incentives to innovation and the efficiency and security of the system”.
This need to balance between financial innovation strategy and management of
4
financial risk remains a challenge to both the regulators and the regulated. Optimal
policy development would be a resolution to enhance such a balancing act.
Application of scientific methods, such as optimization models, has been advocated to
assist in public-sector planning because of their ability to produce planning
alternatives and to facilitate evaluation and elaboration of insights (Brill, 1979).
Implementation of strategic controls could be an interactive process driven by the
overall strategy adopted by an institution. In prior studies about management control
system in a public sector entity, the interrelationship between management control
mechanisms and strategy was in fact found to be an interactive process (Ittner and
Larcker, 1997; Kober et al. 2007). A great challenge for the regulatory body to
implement such a monitoring system is however to maintain its dynamism in
measuring the relevant indicators given the exposures to externalities (Henri, 2010).
4.2
Normative development of risk management and controls
For financial regulatory institutions, they would be concerned about the irregularities
initiated by externalities that could be well beyond their control. Under these
circumstances, precautionary policy measures should be taken among these
organizations to examine the possibilities and these potential impacts to the public at
large (Barrieu and Sinclair-Desgane, 2006). In the experience of the UK financial
regulatory, it was viewed that the Financial Services Authority (FSA)i should be
considered as a risk-based regulator which needed to allocate resources in terms of
supervision and in particular enforcement action to the priority areas (Burger, 2006).
Contingency theory on the other hand is considered essential to study the overall
effectiveness of the public sector organization with respect to pertinent policy setting,
information and communication as well as size of the entities involved (Wood, 2009).
In another recent study, Bhimani (2009) emphasized the significance and
interconnection among corporate governance, risk management and management
controls. Institutions are expected by their stakeholders to strengthen risk
management and to convey related information for improved legitimacy (Bhimani,
2009).
In fact, there have been increasingly normative developments among the professional
communities seeking common understanding of the enterprise risk management
approach. As derived by The Institute of Risk Management, The Association of
Insurance and Risk Managers and The National Forum for Risk Management in the
Public Sector, a set of risk management standard could be adopted by the public
sector organization (Institute of Risk Management, 2002). This standard as delineated
in Figure 1 identified the importance of governance in creating the environment and
the structures for risk management to operate effectively. Similar standard called the
COSO Framework has been gaining acceptance among the accounting and finance
professionals (Ng and Mitchell, 2009).
5
Figure 1 Risk Management Standard
Source: Institute of Risk Management (2002)
5.
Conceptual framework and Research Approach
5.1
Conceptual framework of strategic controls for the financial services
industry.
As pointed out by Kober et al. (2007), there is an underlying interrelationship between
management control mechanisms and strategy. Management control mechanisms
could be bounded by the overall strategic objectives of an organization. On the other
hand, one should recognize the significance and interconnection among corporate
governance, risk management and management controls (Bhimani, 2009).
Stakeholders would expect institutions to strengthen risk management and therefore
management controls for improved legitimacy (Bhimani, 2009). This phenomenon
could be augmented if there were extended public interests at stake.
6
Due to constraints of institutions in maintaining ones’ legitimacy as explained by
DiMaggio and Powell (1983), there could be resistance in imposing reforms to an
existing regulatory architecture bounded by its strategic objectives. The regulators
facing such risk management dilemma would attempt to optimize strategic control
measures aiming to attain a degree of legitimacy while imposing new strategic
controls bounded by the overall strategic objectives.
5.2
Research questions
Prior studies have examined the financial supervision architecture of key countries
and pointed out such relationship with politics and central bank (Pellegrina and
Masciandaro, 2008). However, in relation to such investigation, Hong Kong’s
regulatory system and its development were not included in that study despite its
growing significance as the global financial centre in Asia. Even though there are
concerns over the increasing systemic risk on a global basis, there has been little study
about risk management and policy among the financial regulators. In the first place,
this study aims to explore the organic development of Hong Kong’s financial
supervision architecture under its unique governance system from its days of British
Colony to the post-1997 years.
This paper further makes use of a longitudinal case study approach as advocated by
Fligstein and Choo (2004) in examining the institutional dynamics of the key financial
regulators in connection with the regulated financial institutions in Hong Kong before
and after the financial tsunami in 2008. Mitigating measures through strategic
controls taken to deal with systemic risk influenced by such institutional dynamics
within an established financial supervision architecture are examined. It aims to
investigate the interrelationship between management control mechanisms and
strategy under such a financial supervision architecture of an emerged international
financial centre seeking innovation as part of its strategic objectives.
5.3
Case study approach
Case study is adopted as the research methodology for this study. Yin (1994) points
out that the case study was adopted in a number of situations to explore new
knowledge of individual, group, organisational, social, political and related
phenomena. It is suggested that the case study method enables the investigators to
embrace the “holistic and meaningful characteristics of real-life events”. The case
study strategy would in fact be effective when there is no requirement on the control
of behavioral events but a focus on contemporary events. Moreover, studies of
institutional trends and dynamics could be extended over a period of time as
deliberated by Fligstein and Choo (2005).
Data collected for this study are composed of archival reports, issued financial
regulations, published guidelines and circulars by the regulators. Furthermore,
supplementary interviews were made with individuals who had worked in the
regulated financial institutions during the period of study from 2008 to 2011. There
are 12 of them participated in these structured interviews focusing on their experience
over the changes in operational procedures during the period of time.
6.
The Case in Point
7
6.1
Organic development of Hong Kong’s financial regulatory system: two
main authorities
The Securities and Futures Commission (SFC) is considered as an independent nongovernmental statutory body outside the civil service, responsible for regulating the
securities and futures markets in Hong Kong. SFC was established following the
initial enactment of the Securities and Futures Commission Ordinance in 1989,
subsequent to the October 1987 stock market crash, which resulted in the closure of
both the Hong Kong stock and stock index futures markets for four days (Ho et al.,
2004). SFC has a rather broad, balancing mandate in promoting the fairness,
efficiency and competitiveness of the securities industry as well as providing
protection and education to public investors, minimizing related crime and reducing
industry risks. On the other hand, the Hong Kong Monetary Authority (HKMA) is a
government authority in Hong Kong responsible for maintaining monetary and
banking stability. It was established in 1993 by merging the Office of the Exchange
Fund with the Office of the Commissioner of Banking. Two of HKMA's main policy
objectives are (a) to maintain currency stability within the framework of the Linked
Exchange Rate system and (b) to promote the stability and integrity of the financial
system, including the banking system. It is also described as a “de-facto” central bank
of Hong Kong (Ho et al., 2004).
Despite the defined responsibilities of the two regulators, there are allegedly
overlapping roles between HKMA and SFC in regulating banks involved in securities
businesses. In current practice, SFC registers banks, which undertake securities
business that are constituted as regulated activities under the Securities and Futures
Ordinance (Cap 571) (SFO) re-established in 2003. Financial institutions registered
for this purpose are referred to as registered institutions. Since SFC is the lead
regulator for the securities industry, any entity with an intention to carry on a business
in activities regulated under the SFO must be licensed or registered by the SFC. The
SFC is the authority that establishes the standards, through rules, codes and guidelines
issued under the SFO, with which financial intermediaries are required to comply
when carrying out their regulated activities.
As a regulatory body, HKMA’s main functions and responsibilities are governed by
the Exchange Fund Ordinance and the Banking Ordinance. Moreover, HKMA acts as
the frontline supervisor of registered institutions – banks which intend to involve in
securities businesses. When a bank or an authorized institution (AI) applies to become
a registered institution, HKMA will advise the SFC whether the bank is fit and proper
to carry on the regulated activities for which it seeks registration. To facilitate the
necessary coordination, the HKMA and the SFC signed a Memorandum of
Understanding (MOU) in December 2002 setting out their respective roles and
responsibilities. However, their respective roles and responsibilities in regulating
these banks seem convoluted and unsegregated between the two regulatory
institutions. A summary of the division of responsibilities between the HKMA and
the SFC in regulating these AIs provided in Table 1.1 and 1.2.
8
Table 1.1
Source: Hong Kong Monetary Authority (2008)
9
Table 1.2
Source: Hong Kong Monetary Authority (2008)
6.2 Pressure to reform under a financial crisis
On 25th September 2008, Lehman Brothers Holdings Inc. (LB) filed for bankruptcy
protection under Chapter 11 of the US Bankruptcy Code and its regional headquarters
in Hong Kong proceeded to liquidation. It was revealed that Hong Kong had been a
place designated to arrange for a particular type of structured product – a callable
credit-link note that LB had distributed under the name of “Minibond”, which in fact
contained complex derivative arrangements (HKMA, 2008). The investing public
then realized their investments in “Minibond” investment products spread across a
number of retail banks in Hong Kong lost a significant port of its value and in a
number of cases all of the value upon the collapse of LB. Many banks carried similar
“poison” investment products which provided about disclosures of outstanding credit
ratings by international credit rating agencies.
In response to such losses, these victims interrogated the regulatory system in Hong
Kong and the failures of these joint regulatory bodies: HKMA as the frontline
supervisor of the securities business of authorized institutions to oversee their
governance and internal controls in accordance with standards established by the SFC
to ensure the proper conduct of their regulated activities under the SFO. As of the end
of 2008, HKMA received almost 20,000 complaints in respect of the sale by AIs of
Lehman-related investment products involving approximately a total amount of U$2.6
billion, as shown in Table 2 (HKMA, 2008). SFC reported an addition of 7,000
10
complaints from the public involving at least 16 licensed banks in Hong Kong (SFC,
2008).
The public outcry gave pressure over the accountability and responsibility of
regulating the sales of such high risk investment products to retail-level investors.
These investors were considered as unqualified, lacking the necessary understanding,
to acquire such investments. Moreover, there were complaints about
misrepresentation about the risk profile of the “Minibond”, which were unlikely to be
suitable to some senior citizens who had little knowledge the underlying derivative
arrangement and the investment risk involved. The confidence over the financial
regulatory system was damaged and the public at large questioned the effectiveness of
the existing regulatory measures.
Table 2 Statistics on complaints about Lehman-related investment products
Source: Hong Kong Monetary Authority (2008)
6.3 Vulnerability in the regulatory system
As Hong Kong was well positioned to become the international finance centre for
Asia, SFO’s one of the most significant objectives is to enhance financial innovation
while promoting a fair, orderly and transparent market. The Financial Secretary in his
11
budgetary speech in 2006 also emphasized the need to diversify the range of financial
products available in Hong Kong. Between the period 2006 and 2008, there was
influx of derivatives products in the marketplace as there were supportive gestures at
the policy level for Hong Kong’s emergence into her role as international financial
centre. Banks attempted to diversify their portfolio of offerings with “innovative
investment products”. There evolved a mimetic mode of profit-seeking across the
authorized institutions. In the meantime, Hong Kong continued to uphold its par with
other international financial markets in terms of standards and practices.
Subsequent to the “outbreak” of this “Minibond” incident, the regulators attempted to
explain their roles and responsibilities in the financial market of Hong Kong. SFC as
the leader in regulating securities business particularly emphasized the disclosurebased approach within the regulatory regime over investment products distributed
throughout the retail operations of banks in Hong Kong (SFC 2008). While these
investment products have been reviewed by SFC as to their adequacy of disclosures,
the majority of the affected investors bought these Lehman-related investment
products through their banks.
Nonetheless, the disclosure-based approach enables a wide range of possibilities of
innovation of financial products but also implies potential complexity of structured
investment products linked with the underlying global systemic risk instigated in an
overseas capital market. The regulators apparently failed to take any precautionary
measures on derivatives but continued to rely on proper disclosures to the investing
public. Is there any assessment on understandability of the retail investor about the
underlying risk involved? Who would be capable of explaining such systemic risk
when selling these products driven by sales commissions? These are policy-level
issues relating to the effectiveness in meeting SFC’s fundamental objective to protect
the investors at large.
On the other hand, the HKMA is assigned with the responsibility to supervise
registered institutions following the standards set by the SFC. As prescribed in the
MOU between the two regulators, any complaints relating to the regulated activities
of registered institutions would be handled by the HKMA (HKMA, 2008). The stated
regulatory coordinating activities however seem to be circular referencing and might
not enable an effective and timely monitoring of the securities business operations
among the AIs. There are critics about the existing MOU arrangement between
regulators given its informality and the lack of legitimacy and operational
effectiveness (Yiu et al., 2009).
12
MOU
Figure 2 Key Statutory Bodies in the Financial Supervision Architecture
of Hong Kong
In fact, the focus of inquiry in the aftermath of the Lehman collapse has been made on
the possibility of inappropriate selling practice by banks to the retail investors. Under
the current investigation of this fiasco, the regulators have concentrated on responding
to the enquiries on the adequacy of the regime for the protection of retail investors in
Hong Kong as not all of them are suitable for investing in these rather high-risk
products (HKMA, 2008; SFC, 2008). Internally, did these banks selling these
products have adequate internal control procedures in place in monitoring the frontline sales activities? Have they ensured that their front-line sales possess the
professional knowledge and integrity in marketing and selling these investment
products? And perhaps is there a performance measurement system that balances
short-term sales performance and proper conduct integrated with the overall banking
culture? In a recent development, two frontline employees of an AI were arrested on
suspicion of fraudulently or recklessly induced others to invest.2
6.4
Mitigating measures
While the regulators have examined various options of reform, including a unified
system similar to the UK structure as suggested by Carse (2008), the authorities have
so far expressed their confidence over the existing regulatory system organically built
throughout the past two decades. As reported by Yiu et al. (2009), Joseph Yam, chief
executive of HKMA, indicated that no major surgery of the system would be needed
and reinforced the effectiveness of the existing regulatory system in Hong Kong,
despite consenting potential areas of improvement.
2
Allegedly, two employees of Bank of China (Hong Kong) were arrested March 26 on suspicion of
fraud after being accused of persuading eight customers to invest in derivatives backed by Lehman
between 2005 and 2008.
13
While political stakeholders including the legislative council members criticized the
lack of responsible actors in the system, the officials in Hong Kong and Beijing
emphasized their support for stability of Hong Kong’s financial system – no structural
reform was deemed necessary (Pauly, 2011). After a series of investigation, SFC and
HKMA and 16 distributing banks involved jointly announced that they had reached an
agreement in relation to the repurchase of Lehman Brothers Minibonds from eligible
customers in July 2009.
Using powers under the Securities and Futures Ordinance, the SFC led to arrange the
repurchase scheme jointly with HKMA for 16 Minibond distributing banks in the best
interests of the investing public, which was allegedly to have received a high level of
investor acceptance with the following deliberations among the key regulators:3
“Strong markets, like Hong Kong’s, need strong regulations. This
agreement will provide substantial benefits for the vast majority of customers
holding Minibonds that would not otherwise be received by them and, given
the number of Banks and customers involved, the agreement is a watershed in
the regulation of financial services in Hong Kong,” said the SFC’s Chief
Executive Officer, Mr. Martin Wheatley.
“Specifically, the agreement paves the way for customers who hold
Minibonds to receive a substantial return of their capital. Secondly, the
financial support of the Banks, using the commission income received in the
sale of Minibonds, will expedite the return of the underlying collateral to
Hong Kong Minibond holders. This aligns the interests of the Banks and
customers holding Minibonds. Thirdly the agreement provides the framework
for the Banks to develop higher standards of practice in the future and to
resolve complaints in relation to other structured products. For these reasons,
the SFC firmly believes it is an appropriate resolution of the Minibond issue
with these banks,” remarked Mr. Wheatley.
Mr. Y K Choi, Deputy Chief Executive of the HKMA, said: “The
HKMA welcomes and supports the repurchase scheme and considers it to be
practical, reasonable and in the interests of the great majority of Minibond
investors. The HKMA encourages eligible customers to consider the
repurchase offer by the Banks.”
The Hon Sir David Li Kwok Po, Chairman and Chief Executive of The
Bank of East Asia, Ltd, said on behalf of the Banks: “The Banks are pleased to
have reached this agreement with the SFC and the HKMA which we believe
will benefit Hong Kong as an international financial centre. It evidences our
joint effort to assist the Minibond investors in Hong Kong who have been
impacted by the sudden collapse of the Lehman Brothers Group, and to
reinforce public confidence in Hong Kong’s banking, financial and regulatory
systems. This agreement demonstrates our unwavering commitment to the
good of Hong Kong and the welfare of our customers. We will continue to
work with the SFC and the HKMA to maximise the confidence of our
This report is based on the press release by SFC on 22 July 2009, titled “SFC, HKMA and 16 banks
reach agreement on Minibonds”.
3
14
customers in Hong Kong’s banks, and to ensure that the standards maintained
by Hong Kong’s banks will be in line with international best practice.”
Substantial assistance of the HKMA in the investigation of these cases was
acknowledged by SFC. However, it was criticized that justice for the victims had not
served as the matters were now resolved outside the court.4
6.5
Proposed changes through “add-on” mitigations
Two months after announcing the repurchase scheme, the SFC began a three-month
consultation to solicit public comments on proposals to fine-tune regulations
governing the sale of retail investment products to the public. The comprehensive set
of proposals covered various stages of the investment life cycle, including pre-sale
documentation, disclosure at the point of sale, selling practices, on-going disclosure
during the term of investment, and a post-sale cooling-off period.
Meanwhile the Financial Services and the Treasury Bureau of the Hong Kong
Government proposed in early 2010 the setting up an Investor Education Council and
a Financial Dispute Resolution Centre as enhancement of existing regulatory
framework. These initiatives are considered an “add-ons” to the existing architecture
aiming to prevent the public from entering into improper investment schemes as well
as to mitigate legal issues as a result of on-going pertinent disputes within the
financial institutions. No major reform of HKMA and SFC has been proposed. It is
likely that these aftermath mitigating mechanisms would be quite different from the
“Twin Peaks” approach that would refine the specific roles and responsibilities of
HKMA and SFC in regulating the banks in securities business. As such, the
specialized-model in Hong Kong would linger on similar to certain jurisdictions in the
world as reflected in the study by Pellegrina and Masciandaro (2008). 5
6.6
Normative development among the regulated
6.6.1 Coercive forces from the regulators
Although no major reform was made to the current financial supervision architecture,
the regulators have provided a number of guidelines for the licensed banks to
implement. Significantly, a detailed list of recommendations by HKMA was issued to
authorized banking institutions requiring them to implement proper control
procedures within a time frame subsequent to the HKMA’s Report on Issues
Concerning the Distribution of Structured Products Connected to Lehman Brothers
(HKMA, 2008).6
For instance, as reported by Ng and Ng (2011), “Democratic Party lawmaker Kam Nai-wai, who
supports the investors, believed those who choose not to take the ex-gratia payment would continue to
make claims against the banks. He said the amount of the ex-gratia payment was insufficient to reflect
the banks’ responsibility”.
5
In addition to HKMA and SFC, the two main specialized financial regulators in Hong Kong are
Office of the Commissioner of Insurance and Mandatory Provident Fund Schemes Authority
respectively responsible for regulating the insurance industry and retirement fund investment schemes.
6
This notification was issued by HKMA on 25 March 2009 as a circular to the authorized banking
institutions.
4
15
Nevertheless, there have been no restriction on the similar types of financial products
sold these networks – in other words, financial innovation has not been discouraged.
The banks are however advised to establish risk management measures in approval of
financial products to be sold through their networks.
6.6.2 Mimic – Cloning of “Add-ons” Risk Control Measures
As reflected by staff working in the retails operations, many investors have suffered
huge losses when purchased Lehman-related investment products in HK which have
deteriorated the customers' confidence in the banking industry. Banks have
proactively changed their operation guidelines afterwards to strengthen customers’
protection and to rebuild their trust. Major changes in practice are summarized in
Table 3.
Areas of Practice
Before the incident
Required implementation
Audio Recording
Requirement Pertaining
to Sales of Investment
Products
Access to Clients’ Depositrelated Information
Not required
Audio record the process of conducting
customer risk profile assessment and sales of
investment products to retail investors
Frontline staff was easy to access
Staff can only access to and utilize clients’
deposit-related information
for providing investment or wealth
management services with their written
consent
Cooling off period on selling
investment products
No such arrangement
When buying applicable unlisted structured
investment products, investors may exercise
the right to cancel their order or unwind the
transaction and receive a refund
Commissions, fees and other
benefits’ disclosure
Not required
Staff are required to disclose any monetary
benefits or trail commission from product
providers for each investment product
sold/invested
in by clients before sale
Mystery Shopping
Programme regarding Banks'
Sales Practice
Not necessary or taken
by bank itself
Taken by SFC and HKMA to understand the
sales practices of intermediaries in respect of
selling practices involving unlisted securities
and futures investment products and
structured deposits
Physically segregation of
retail securities business
activities from ordinary
banking business at branches
No specific place designated
All investment activities can only take place
in "investment corners" distinct. To provide a
clearer physical differentiation between
traditional deposit-taking and retail securities
activities.
Statement for Derivative
Products traded on an
exchange
Not necessary
To ascertain clients’ knowledge of
derivatives, clients have to sign and
read the statement for derivative
products before investment
Sufficient understanding
of products and disclosure of
product information
sales staff might not well
understood the recommended
products or provision of
insufficient information
Sales staff has adequate training before
selling and has to provide relevant
information to investors. The information
should be presented in a manner that is
appropriate to the target investor and in a
format that can be easily understood
16
Suitability Obligation
Did not take into account of
client’s suitability and provide
sufficient explanation
Sales staffs have to seek information from
client’s suitability assessment. To ensure
about their financial situation, investment
experience, objectives, knowledge and
horizon together with risk tolerance, etc.
Table 3 Summary of Key Changes in Internal Control Practice
6.6.3 Normative – learning from the past and the peers
Although the new operation procedures appear time-consuming for investors and
bank staff when dealing in investment, these new procedures as implemented in 2010
seem effective in strengthening the regulatory regime about investment products,
conduct and selling practices of intermediaries.
As observed by the interviewees, the intermediaries are required to discharge their
duties with due skill, care, diligence and claimed to assess whether the products were
suitable for customers. It helps to ensure that investors can acquire the latest and
accurate information with complete product disclosure without misinterpretation in a
misleading or unfair manner. The alleged advantage is that the investors would be
able to make an informed judgment of their investment so that their interests can
sufficiently be protected. It could enhance protection for the investing public as well
as strengthens Hong Kong’s position as an international financial centre.
Training and development activities on these strengthened internal control procedures
were also increased in the subsequent time period. New employees are also given
orientations to understand these strengthened procedures.
7.
Discussion
7.1 Organic development and externalities
The Hong Kong financial supervision architecture has been demonstrated to be
equivalent to the specialized model as prescribed by Pellegrina and Masciandaro
(2008). It has the similar characteristics among other specialized-model regulators in
the world that are influenced by a strong “central bank” and the government’s
“Grapping Hand (GH)” approach. As furthered by Pellegrina and Masciandaro
(2008), “it is possible that the GH policymaker will preserve the central bank’
supervisory tasks, although mitigated by the presence of other supervisors. The
reason for mitigation is that this kind of policymaker can also dislike the central bank
involvement in supervision, since she/he fears the creation of an overly powerful
bureaucratic agency that can reduce his/her possibilities to design policies aimed at
pleasing, time to time, all vested constituencies.”
7.2 Institutional isomorphism and dynamics
Despite the material impact on the financial services sector, the two key financial
regulators in Hong Kong have deterred the critics about the necessary reforms over
the existing financial supervision architecture. Despite the increasing dynamics and
challenges in the global financial centre, neither regulatory reform nor restructure is
considered as a preferred approach by the regulators contrary to the prior study by
17
Morton and Bodie (2005). As remarked by DiMaggio and Powell (1983),
isomorphism of institution would be observed through a constraining process that
forces one to become alike with another unit under similar environmental conditions
but not necessarily to become more efficient. Although SFO’s objectives remain the
same, similar investment products are allowed to be sold based on product disclosure
approach with measurable enhancements on risk control procedures. From a macro
policy perspective, the regulators in Hong Kong are inclined to seek an optimal risk
management approach to mitigate such inherent deficiency. New guidelines
pinpointing operational risk management are required to be implemented among the
regulated.
7.3 Seeking optimal risk management through strategic control measures
The incident reflected that the organic developmental experience in Hong Kong
reform would unlikely be accommodated for the rapid global financial innovation or
complexity in investment product development linked with implausible risk exposures.
Banks’ augmented involvement in securities business was unanticipated during such
organic development. Did the regulators make adequate assumptions about the
underlying innovation risk when initially designing the supervision architecture and
during subsequent reviews?
If appropriate responses were to be made, the regulators would have to consider a
comprehensive approach for of risk management within the existing architecture as
stipulated in prior studies (Ng and Mitchell, 2009; Woods, 2009). Firstly, there ought
to be precautionary measures in light of the increasing complication with global
systemic risk. Relevant policy should be in place to prevent any implausible risk
exposures to the public at large. Secondly, the ineffective elements within the
existing financial supervision architecture need to be mended with enhanced
operationalization of monitoring and controls systems instead of relying on a rather
convoluted MOU and procedures between HKMA and SFC. Timely information and
communication enabled through an interactive management system would be critical
for the regulators to reveal information about any problematic practices among the
regulated (Wood, 2009). Thirdly, other preventive measures would include utilizing
“mystery shoppers”, strengthening routine enforcement and on-site inspection or audit
activities imposed upon the regulated.7 Moreover, especially for the sizable banks
involved in securities business, they would have to implement effective enterprisewide performance measurement and risk management system integrated to ensure
staffers are aligned to comply with the regulatory requirements. Proper internal
control procedures should be in place and any control weaknesses need to be
identified and dealt with in a timely manner. Proper disclosures about their financial
products need to be printed in the brochures and explained to the investors clearly.
7
According to HKMA (2008), since 2005 an increasing number (50 for 2008) of large, complex or
active registered institutions (including all the active retail banks) have been required to commission
only annually an independent unit (for example, their compliance department) to review the
institution’s 39 compliance with the regulatory requirements of the SFC and the HKMA concerning
regulated activities. The units’ reports are reviewed jointly by the institutions’ case officers and the
Securities Supervision Team. Common issues arising from the assessment of the reviews from 2005 to
2007 included inadequate controls for ensuring the accuracy of relevant individuals’ registration details,
and breaches of the Securities and Futures (Contract Notes, Statements of Account and Receipts) Rules.
A few registered institutions were reported control deficiencies in relation to the marketing of
investment products.
18
In particular, the above measures can be characterized as strategic controls
implemented within the established financial supervision architecture. On one hand,
the overall policy to sustain financial product innovation has not been abolished as
Hong Kong continues its strategic positioning as the international financial centre not
only for Asia but more critically for China.8 While this strategic objective is to
continue in the foreseeable time, risk control measures have been development and
implemented within the system including the array of licensed banks that are involved
in handling securities business. These strengthened internal control procedures are
meant to reduce the risk of similar incidents from happening in an extensive manner
given her policy strategy as an international financial centre.
Precautionary Public Policy
(product profiling, risk policy)
Strengthening
coordination in
regulatory
matters
HKMA
Monitoring
Inspection/
“Mystery
Shopping”
Banks
-
Banks
SFC
Enforcement
Approval
Banks
Banks
Strengthened internal control measures
Enhanced disclosure-based risk
management
Figure 3 Optimizing Strategic Controls in a Financial Supervision Architecture
8.
Concluding remarks
8.1 An organic financial regulation architecture with explicit objectives
In conclusions, this study reveals an organic development of a specialized financial
regulatory architecture that is uneasy to transform itself despite significant impact of
externalities. It has reinforced the prior studies about similar dynamics in other
jurisdictions (Pellegrina and Masciandaro (2008). Radical reform of such architecture
seems distant if not impossible. Furthermore, the concept of institutional
isomorphism is contemplated for its relevance in explaining the need to retain
legitimacy within a regulatory system. Such legitimacy is attempted to sustain
8
Hong Kong is now considered to be an offshore, international financial centre for handling Chinese
Yuan settlement.
19
through incorporation of new measures to mitigate the inherent weakness.
Nevertheless, this study does not find the necessary reform initiatives in a financial
regulatory system under a dynamic environment of economic growth as suggested by
Morton and Bodie (2005). Institutions nevertheless in this case have demonstrated to
maintain their legitimacy through defending, rationalizing and strengthening their
existing roles with organic developments.
In a report presented to the Legislative Council of Hong Kong by Carse (2009),
“There is no perfect model of an integrated regulator. All the various options have
their pros and cons, the balance between which can only be determined by the
particular circumstances of each jurisdiction”. Despite these pros and cons, this
study reveals that the regulators could still upgrade risk management for feasible
improvement through dynamic risk control measures at the policy, compliance and
operational levels. This phenomenon reflects a mode of strategic controls within such
a regulatory system in response to the systemic risk instigated under a global financial
system. Such strategic control measures are both interactive and responsive to
externalities (Kober et al. 2007; Ittner and Larcker, 1997). Nevertheless, this case
study further suggests that such strategic controls are bounded by the overall strategic
objectives that constraint the range of mitigating risk control measures as well as a
radical reform of the existing architecture.
8.2
Institutional dynamics in strategic controls and optimal risk management
In this post-financial crisis analysis, the regulated financial institutions are found to
swiftly respond to strengthen their risk controls through compliance with the
guidelines imposed by the regulator. These strengthened strategic controls however
appear to be contingent to significant adverse impacts over the existing regulatory
system and the resulting demand from the stakeholders. This situation suggests that
contingency theory used to study for risk management and related controls could take
into consideration of such adverse external incidents (Wood, 2009).
Moreover, in this case, institutional dynamics in influencing the implementation of
risk controls through a top-down interactive mechanism is observed. Such dynamic
and pertinent rapid responses induce the pursuit of optimal risk management within a
regulatory framework. Mitigating risk controls measures are strengthened aftermath
of a financial crisis. Having experienced such a significant adverse impact, regulatory
institutions attempt to take precautionary, coercive measures for the regulated to
mimic and implement prudent mechanisms. Mitigating measures are instituted by the
regulators who attempt to balance between continuing financial innovation and risk
management for the market as a whole (Carbo 2010).
Temporal optimal risk management guidance is developed by the regulators for the
regulated to follow and implement. The implication is that the regulator with exposure
to extended public stakeholders is stimulated to take a proactive and optimal approach
in policy making before another crisis may come again (Brill, 1979; Barrieu and
Sinclair-Desgane, 2006). This study also demonstrates that the regulator has the
power to institute risk management through a top-down effect of strategic control and
related risk control measures (Bhimani, 2009; Ng and Mitchell 2009).
20
In reflection, periodic review of effectiveness of the overall risk controls would be
crucial to anticipate systemic risk in order to prevent and minimize such adverse
impact to the investing public stakeholders at large. It becomes critical to identify any
unrecognized risks that could now become more likely to emerge than before
positioning as an international financial centre under a global economy.
Precautionary risk control measures need to be formulated as investing public’s
confidence might not be reinstalled solely through risk mitigating measures with
investor education and aftermath dispute resolution mechanisms.
8.3
Limitation
This is a longitudinal case study over a financial regulatory system that may not be
entirely relevant to other international financial centres under differentiating
circumstances.
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