Hong Kong’s International Financial Centre: Retrospect and Prospect

excrept concerning Minibonds :

Louis W. PaulyReport for the Savantas Policy Institute
(founded by Regina Ip)
5 February 2011

7. Relative to the recent experience of the United States and much of Europe, and to its own experience ten years earlier during the Asian crisis of the late 1990s, in 2008 Hong Kong’s crisis management system proved reasonably robust. The bankruptcy of Lehman Brothers,however, and widespread allegations that the risks and fees associated with so-called minibonds bearing the Lehman name had been misrepresented by many Hong Kong intermediaries, revealed serious flaws in governance at a number of levels.

8. Across the advanced economies of the world, including Hong Kong’s, the crisis of 2008 suggested the need for more pro-active and less reactive government. But balancing the competitive impulses required for continuing prosperity in financial markets and durable expectations of overall stability and safety requires subtlety. For Hong Kong it also requires the maintenance of relative autonomy both internationally and inside greater China.

9. At the global and regional levels, Hong Kong’s government has already proven its ability to think strategically and act constructively as financial regulatory and supervisory policies are adjusted. The joint work of FSTB and the HKMA during and after the crisis of 2008 suggests that to strengthen today’s IFC in Hong Kong a single entity ‘above the fray’ needs to be in a position to think strategically about healthy financial markets in Hong Kong and their relationship with the broader economy. It should be a permanent secretariat and longterm think-tank for the Council of Financial Regulators.

10. Closer to the markets, a version of the UK’s planned Prudential Regulatory Authority, as a distinct and distinctly mandated subsidiary of the HKMA, should be considered. Under its stability mandate, the HKMA should remain in a position continually to re-assess and guide macro-prudential policies, especially as they apply to systemically significant banks and the migration of systemic risks, arising, for example, from institutional scale, crossborder links, and interconnectedness, ostensibly outside the banking system. International
comparators should also inform continuing reconsideration of the relationship between the SFC and the HKEx. Similarly, comparative analysis should influence continuing debate on moving beyond arbitration procedures to the establishment of a separate, cross-sectoral agency for consumer protection.

11. There is no reason to tamper with the HKMA’s primary responsibility for managing the Exchange Fund. But the current scale of reserves and the expansion of cooperative
facilities with China and regional partners call for reconsideration of very conservative investment practices. A sovereign wealth fund may not need to be explicitly carved out, but the return on a serious portion of existing and future reserves could reasonably be benchmarked against the performance of SWFs in comparable jurisdictions.

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Derivatives and synthetic securities

Although the global crisis of 2008 prompted many market observers to question the difference between investing and gambling, the investment vehicles that caused the most trouble were not really new. Rather, the risks they represented, the scale of those risks, and the essential implications of contagion from a systemic crisis of confidence were all misunderstood and mismanaged. In the wake of the crisis, Hong Kong is collaborating with other jurisdictions around the world to improve the basic infrastructure through which various kinds of financial derivatives and synthetic securities, like synthetic exchange-traded funds, are handled.

For derivatives, the HKEx is establishing a clearing house for over-the-counter derivatives.
This complements recently announced plans of the HKMA to maintain a central registry and database of OTC activity. With the latter improving market transparency and the former reducing clearing risks, since the clearing house serves as counterparty for both sides a trade, the aim is to make Hong Kong a relatively more attractive centre than its regional competitors.

Interest-rate derivatives will open the market, and equity derivatives are expected to follow. Eventually, dealers expect to be able to offer variations on such products denominated in RMB. The main securities market regulator, the Securities and Futures Commission (SFC), is consulting market participants on appropriate supervisory structures.45 Similar issues regarding appropriate disclosure of risks and data on pricing confront instruments like synthetic exchangetraded funds. Parallel work programs are therefore underway within the HKEx and the SFC.

More on this below, but it is obvious that regulators want to keep Hong Kong markets abreast with regional and global competitors without also repeating transparency-related problems like those encountered with Lehman mini-bonds in 2008.


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Wealth management

At the intersection of commercial and investment banking as traditionally defined are
rapidly expanding financial services organized under the banner of asset or wealth management.

At the most sophisticated end of the retail market for such services are high net-worth individuals and firms open to new strategies for investing in stocks, bonds and other fixed-income instruments, foreign-currency instruments, real estate, private equity funds, hedge funds and other types of managed funds. This clientele is obviously growing in Hong Kong itself, and many of their counterparts technically still resident on the Mainland are becoming more prominent participants in Hong Kong’s market for asset-management services. A range of similar kinds of services also exists for non-profit and for-profit institutions, as well as for financial intermediaries operating at least in part out of Hong Kong. Hong Kong’s low-tax system attracts wealth holders, and the market for high-end advisory services develops in train.

Nevertheless, given conservative banking habits, and controversial episodes associated with alternative investment vehicles like ‘mini-bonds’ issued by the ill-fated local subsidiary of Lehman Brothers, innovation in the field of wealth management in Hong Kong has not been straightforward. Real estate investment trusts, for example, were only authorized in 2005, and they attracted controversy from inception. REITs are essentially mutual funds for real estate driven partly by corporate tax advantages deriving from the requirement that 90% of associated income be distributed to investors. The Hong Kong Housing Authority launched the first one as soon as the SFC gave it permission to do so. Although it was substantially oversubscribed, groups fearful of the implications for the future availability and pricing of public housing objected. Later issues were modest and the financial performance of the trusts has been disappointing.

Despite the challenges, wealth management looks set to become a much more important
source of activity for Hong Kong’s IFC. The seeds have already been sown. Private equity pools, hedge funds of various kinds, and alternative investment vehicles comprise a fast-growing sector. Bolstering their growth have been recent regulatory moves in the United States and Europe aimed at pushing riskier and more speculative activities out of banks and bank holding companies. At base, however, it is the search for yield that simultaneously seems to be pushing them out of developed markets and toward perceived new opportunities, not least in greater China. Hong Kong’s strategic position in this context is obvious. Less obvious are associated
risks.

Net capital flows from the Mainland are expected to contribute significantly to the demand for asset-management services, but of those flows the HKMA estimates that Hong Kong will retain around 10%. The liberalization of the RMB will increase flows both ways, but the HKMA recently announced that RMB deposits in Hong Kong-based banks totaled RMB 279.6 billion (US$42 billion) as of November 30, 2010, an increase of 29% from the previous month and 246% from a year earlier.52 By the end of 2010, 67,000 Mainland firms had been authorized to settle cross-border trade accounts in Hong Kong, facilitated by an expanding currency swap arrangement between the HKMA and the PBOC. Since this growth also increased the risk that unauthorized transactions would take place, Hong Kong’s banks were directed especially to
monitor transactions in large amounts by new customers or between firms known to be related to one another. In any event, even as Hong Kong-based firms continue to invest heavily on the Mainland in anticipation of continuing rapid growth and currency appreciation, the amount of Mainland wealth invested in and through Hong Kong will surely grow as well. Capital controls have typically had a portfolio diversification effect elsewhere, and, even when flows are perfectly legitimate, differences in tax rates can be expected to reinforce such an effect.

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Market participants routinely suggest that much work remains to be done to build the infrastructure of Hong Kong’ stock and bond markets, so the business of local investment bankers and financial advisors is likely to remain robust. While no one complains about the opportunities presented by IPOs and offshore RMB instruments, pressures are mounting both for further diversification and for more competitive pricing. It is worth noting here that the monopoly of the Hong Kong Exchange is frequently questioned in this regard. But so too is the sustainability of the profits of intermediaries that depend upon sales of investment products to retail investors. The Lehman Brothers mini-bond incident of 2008 shed much light on the regulatory and supervisory underpinnings of changing investment and commercial banking markets in Hong Kong, and we examine it in more detail later in this study.


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Consumer protection

The fundamental challenge is hardly novel or unique. In a world of free and more open
financial markets, does the responsibility of governmental authorities extend beyond the most basic matters of licensing, establishing and adjudicating property rights, and otherwise ensuring that competition in those markets takes place on a level playing field? The current answer everywhere in the world where capital flows relatively freely is ‘yes.’ That, however, is where full agreement stops. The follow-up question has necessarily normative cast. Where should we draw the line between governmental responsibility and the responsibility of individual market participants? Answers vary, both across national borders and within them.

Certainly before the handover in 1997, the traditional answer in Hong Kong was that the role of government should be as limited as possible. As long as the society in which a relatively free and unrestricted financial market is embedded is flexible and capable itself of adjusting quickly to internal or exogenous economic shocks transmitted through those markets, then financial openness and minimal official interference should produce prosperity. As noted above, several decades ago something like such an expectation might have guided official decision-makers in Hong Kong. Nevertheless, the actions taken by their successors during each major financial crisis since 1973, and certainly the actions taken during the crisis of 2008, strongly suggest quite another expectation and quite another understanding of Hong Kong’s society.

The saga of the Lehman Brothers mini-bonds in Hong Kong well illustrates the point. Its observable conclusion is an evident social and political consensus to support a more interventionist set of financial regulatory policies, including policies designed to protect the consumers of financial services (from unclear risks and excessive fees) and to impose fiduciary legal obligations on intermediaries selling such services. The surrounding events also suggest a new understanding that such obligations rest not simply on the shoulders of private intermediaries but also on government. In short, it repudiates traditional notions of caveat emptor. Together with the evolution of such practices as mandatory insurance coverage for bank deposits, governments in Hong Kong will in the future likely find it more difficult not to respond to social demands for protection from sudden or widespread financial losses, even when such losses do not threaten overall market stability. Again, to some observers and participants who valued the freedom they once found in Hong Kong, this is a matter of some regret. For present purposes, the main point is that Hong Kong has joined most other advanced economies in this regard.

Lehman mini-bonds and similar instruments were sold in many countries, but their
unwinding cast a particularly harsh light on the limits of Hong Kong’s rules governing the selling of financial products to retail investors. The same lesson had been learned elsewhere during earlier crises. Transparency, or full disclosure, in the selling especially of complex products by banks is not enough. Light-touch regulation to discourage mis-selling by institutions the public typically sees as insured or at least closely watched by government is not enough.

Traditional understandings of the fiduciary obligations of banks to their customers are now reinforced with the threat of penalties or enforcement efforts designed to elicit ‘voluntary’ compensation. In a new era of structured financial products with tempting returns and vague risks, especially to investors hardly qualified as ‘professionals,’ the idea of ‘self-regulation’ rang hollow.

The fact that Lehman Brothers itself was ultimately at risk in the event of a default on the mini-bonds sold by Hong Kong institutions with permission of the SFC was not entirely clear at the point of sale. Even if it had been, investors may well have imagined that the Lehman name was undoubted. The truth is that no one expected the firm to be permitted to go into bankruptcy in 2008, and even if they had, certainly no one should have expected its American overseers to be so cavalier in their consideration of liabilities not domiciled in the United States. When that
bankruptcy nevertheless did occur, contagion spread across borders like wildfire in a dry forest.

Under British law, for example the London subsidiary of Lehman ceased business immediately.
The holders of Lehman Brothers mini-bonds in Hong Kong suddenly found themselves facing staggering losses. Having authorized their sale, under the Securities and Futures Ordinance and the Companies Ordinance, the SFC in turn found itself the target of intense political reaction. As the main regulator and supervisor of banks selling the Lehman instruments, the HKMA was drawn into the ensuing controversy as well.

In short, some 44,000 investors bought nearly HK$16 billion in mini-bonds guaranteed by Lehman Brothers. They might well have turned out to be low-risk, high-yield investments. With the unexpected collapse of the firm, however, they in fact turned into under-valued claims at the tail-end of a long and complicated unwinding process. With the HKMA and SFC awash in complaints from the holders of those claims, and the government under mounting pressure from the LegCo, the sixteen banks that had distributed the mini-bonds eventually agreed to repurchase them. They ‘voluntarily’ bought most of them back at prices varying between 60 and 70% of
their nominal value, depending on the age of the bond-holder, plus an additional payment reflective of any recoveries the banks themselves were eventually able to make in the Lehman bankruptcy process. For the time being, at least, the cause of diversifying the financial holdings of most Hong Kong citizens was set back. The local development of wealth management services promised long to be marked by the experience.

At the same time, a precedent had been set to extend outward the implicit safety net under banks licensed to do business in Hong Kong. Public consultations during 2010 on the idea of establishing an insurance authority at arm’s length from the government covered some of the same terrain Turning the clock back to the days of non-interventionism--positive or not-- seemed entirely unrealistic. Likewise, future reliance on the ad hoc management of markets during crises seemed imprudent. As has happened elsewhere, therefore, following in train from the crisis of 2008 was a fully justified debate on a new and more effective system of financial oversight. The questions that inevitably followed focused on the modali ties of that system.