Risky Business

A major overhaul of Hong Kong’s financial regulators may be required following the minibonds scandal, writes Justice Lai.

If the new year is a time for fresh starts and self-improvement, the reports produced by the Securities and Futures Commission (SFC) and the Hong Kong Monetary Authority (HKMA) on December 31 couldn’t have been more timely. Submitted to Acting Financial Secretary Professor KC Chan and promising suggestions on “how Hong Kong can improve its [financial] regulatory framework and enhance investor protection and education,” the reports were prompted by the local minibonds debacle that followed the collapse of US investment bank Lehman Brothers last year.

The suggestions themselves have yet to be made public, but many agree that serious corrections are well in order. According to the HKMA, over 40,000 local investors purchased Lehman-backed investment products, $12.6 billion of which were “minibonds.” Many low-income, elderly citizens put large portions of their entire savings into the latter under the impression that they were buying stable, low-risk corporate bonds. Only with the collapse of Lehman, and subsequently most of their savings, did they realize they had really invested in risky, complex derivatives attached to the US financial giant.

As to how they got drawn into such investments in the first place, their supporters point to mis-selling by local banks. Only in Hong Kong and Singapore were such products sold at retail level, in some cases to people who are illiterate. Supporters of the victims in Legco say the banks failed to explain the full nature of the products and the risks involved to customers, as they are required by existing regulations. “We have a very detailed regime requiring banks to assure investors of the risks, and I don’t think these were followed,” says Civic Party legislator Ronny Tong. He adds that numerous pamphlets distributed by the banks were “questionable,” often not properly stating that the products being sold were not traditional bonds.

Yet the banks aren’t the only ones being blamed. Many say that authorities such as the HKMA and SFC are culpable, too. “There’s been a failure on the part of the regulatory bodies,” says legislator Audrey Eu. “They did not make sure that the bank staff selling these products were complying with the code of conduct.” That code requires sellers to distinguish between professional and ordinary investors, professional investors being those with at least US$8 million.

This lapse in regulation has been attributed to the outdated and inefficient structure of the authoritative bodies. Traditionally, brokerage houses have peddled high-risk investment products, while banks restricted themselves to selling stable bonds. Accordingly, two separate bodies were set up to monitor these different transactions, the SFC monitoring the brokerage houses, and the HKMA monitoring the banks. Now, however, banks have begun selling products traditionally sold by brokerage houses. “The boundary between the two different types of financial institutions has become blurred, and the HKMA is less experienced at regulating the new practices taken on at banks,” says Stephen Cheung, professor of finance at the City University.

In response, Cheung advocates setting up a firewall within banks to separate those selling high-risk investment products from those selling low-risk ones, whereupon the former could then be properly monitored by the SFC. Others support more far-reaching changes to the system. Webb-site.com, run by well-known investor-protection activist David Webb, has called for all the financial services regulators in Hong Kong—the HKMA, the SFC, the Mandatory Provident Fund Schemes Authority (MPFA) and the Office of the Commissioner of Insurance (OCI)—to be unified into one single body that would be equipped to oversee the issuing and sale of all financial products.

On top of such regulatory streamlining, Webb calls for a statutory “cooling-off period,” during which clients can reconsider and cancel any purchases they made in a high-pressure sales environment (where they may not have had time to go through the relevant material about their purchase). He also advocates mandatory disclosure of all commissions paid to banks for such sales. It remains to be seen how extensive the SFC and HKMA’s own recommendations will be—and how well the government will respond to them—but observers such as Webb warn that action is crucial. “Without such reforms,” he warns, “there is a risk of either repeated crises or an outright ban on the sale of such products.”

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