China Banking Regulatory Commission Market Risk Analysis Seminar New Product Risk Management for Mainland Banks Andrew Sheng Chairman Securities and Futures Commission Hong Kong 20 July 2005
Contents of Lecture • Challenges faced by Mainland banks in moving towards new products and risk management • Hong Kong experience in introducing new products, eg warrants, structured products • Regulators’ role in product introduction and process to manage Risk Management skills of banks issuing such products 2
Changing Demographics changes Consumer Demand • Rise of affluent class of savers demands new range of products, services and wealth management skills • Mainland banks are facing unprecedented rapid reforms to match best industry practices and international standards • Risk management skills are top priority if Mainland banks are to compete with increasing foreign banks after WTO opening 2006-2007 3
Asian Demographics: Rise in Working Age Group increases savings and demand for new services 4
Calculation of Risks “In making any decision about risk, the logical first step is to try to determine at what point additional risk no longer carries potential rewards that exceed the potential losses, given the respective probabilities of the good and the bad.” Robert Rubin, former US Treasury Secretary, “In an Uncertain World”, 2003 5
Common Corporate Risks • Credit risk • Market risk • Operational risk • Liquidity risk • Legal risk • Regulatory risk • Systemic risk • Political risk • Reputation risk 6
3 Major Risks Facing Mainland Banks • Credit risk (80%) – NPLs – Fraud risk is often tied up with NPLs • Market risk (10%) – chiefly interest rate risk - FX risk if RMB becomes flexible • Operational risk (10%) – Internal controls and governance systems still evolving 7
Mainland Banks Relying mainly on Interest Income (2004) • Unlike major international banks, mainland banks are too reliant on net interest income, leading to higher credit and interest rate risks. • From a risk management perspective, important to develop non- interest or fee-based income. • Objective is to find optimal mix of interest income and non-interest income. 100% % of Interest Income % of Non-interest Income 80% 60% 40% 20% 0% ICBC BOC CCB ABC Citigroup HSBC Bank of UBS America 8 Note: figures of ICBC and ABC are for 2003. Sources: Annual Reports of various banks
Loans are important in banks’ asset portfolios (end 2004) Interest income will continue to be the single most important revenue source for Mainland banks. However, there is a need to consider other income sources. Loans / Assets Ratio (%) 64.3 Industrial & Commercial Bank of China (ICBC) 48.5 Bank of China (BOC) 57.0 China Construction Bank (CCB) 64.9 Agriculture Bank of China (ABC) 36.2 Citigroup 52.5 HSBC 45.2 Bank of America 13.4 UBS 9 Note: figures of ICBC and ABC are for 2003. Sources: Annual Reports of various banks
U.S. Experience – Moving towards fee-based income In the early 1980s, the ratio of interest income to fee- based income for U.S. commercial banks was 8:2. This ratio has increased to 6:4 since late 1990s. Sources: 40/2004 Economic Perspectives, “How do banks make money? The fallacies of fee income”, Federal Reserve Bank of Chicago 10
The shift to fee-based income has been driven by • Deregulation: commercial banks are allowed to engage in other financial services, e.g., investment banking, securities brokerage, insurance agency, asset management, etc. • Strategic decision by banks to diversify revenue sources and to identify new fee-based income from traditional banking services, e.g., deposit account services, trust account/wealth management services, loan origination and services, credit cards, etc. • Advances in technology enhance service quality and increase customer convenience, allowing banks to charge for such services separately. 11
Moving towards Fee-based Income requires complete re-engineering of the workflow of banks, creating new risks • Mainland banks already have large exposure to NPLs from traditional banking services, because credit risk management still remains weak. • Not all major foreign banks succeed well in moving into non- traditional fee-generating activities (e.g., proprietary trading, securities brokerage, sale of various financial products). • This requires complete change in core competencies and staff training – from document processing (eg loan evaluation and due diligence) to customer service quality, marketing and managing compliance and back-office processing for wealth management products 12
Need to develop totally new core skills, with tremendous shortage of such skills in Mainland • Fee-based income is knowledge-based service, with need for core skills in:- – Marketing and Sales – Distribution Channel Management – Execution of sales [eg insurance, credit care, wealth management products] – Product development – Risk Management – Compliance and back-office controls • Fee-based income also requires cross-selling, which means not only changes in documentation, accounting and reporting, processes and complete re-writing of IT software, including hardware configuration. • This explains why re-engineering costs in many foreign 13 banks are very high and not all succeed
HK Experience – Banks’ Expansion into New Financial Products • In Hong Kong, commercial banks are permitted to engage in other financial services – securities, asset management, insurance, etc. • The larger ones have taken advantage of the opportunity to design and package new financial products, including new channels (eg Internet banking) to meet the needs of investors and customers and to open new revenue sources. • Besides the traditional interest rate or foreign currency related products, many have recently expanded into equity- related products, in particular, the derivative warrants and structured notes markets. • Banks are finding that training staff to understand new lines of products and new regulations not easy to manage. 14
HK Advantage – Banks can take care of themselves in introducing New Financial Products • In Hong Kong, the regulators leave the commercial banks to look after themselves in all areas of due diligence, systems and staff training when they wish to launch new products. • On specific products, eg banking, insurance, Mandatory Provident Fund, securities, bonds, they have to apply to the relevant regulator to ensure that the product is legally approved for sale in Hong Kong • Each HK regulator approves such product according to different laws and regulations. Unless the license forbids the bank or broker from engaging in the sale of such products, we generally assume that the bank or broker can take care of its risks, unless our specific audit or inspection tells us otherwise. • We would soon know whether there are problems if there are sufficient consumer complaints about quality of service. 15
HK Experience – Derivative Warrants • Total issue size in 2004 was about US$18 billion (accounting for about 27% of total funds raised in 2004) • In Q1 2005, total issue size was US$4.2 bn (the amount of equities funds raised in the same period was US$3.8 bn) 16
Banks’ Participation in Derivative Warrants • Most active issuers of derivative warrants in Hong Kong are European commercial banks, e.g., SG, KBC and BNP (HKEx was the most active derivative warrants exchange in the world in 2003 and 2004). • In 2004, European commercial banks issued 750+ derivative warrants in Hong Kong, raising a total of about US$9.5 bn. • The number of issues was about 60% of the market total, whilst the aggregate issue size was about 53% of the market total (the rest was mainly issued by investment banks). 17
HK Experience – Structured Notes • Structured notes are increasingly complex (e.g. with a knockout feature or linked to a basket of stocks). • The issue size of structured notes including both retail and wholesale markets appears large (around US$10 bn per annum according to market estimate). • Structured notes are mainly issued through private placement, but becoming more popular for retail investors (selling through the commercial banks’ retail network). • The private banking area is not regulated by HKMA nor SFC, because it is assumed to be high net-worth customer area. 18
Market Risk – Financial Derivative Products • Derivatives with option-like features (e.g. derivative warrants, equity-linked structured products) are trading volatility. • Issuers of these products need to use the underlying equity market to hedge their positions. Whether the liquidity of the equity market is sufficient to accommodate such hedging activity is critical to the risk management of the products and market stability. • Regulators need to strengthen infrastructure to facilitate hedging activities by issuers: – Allowing (covered) short selling in the stock market is important to issuers of financial derivative products for risk management purposes – Promoting stock borrowing and lending market (a prerequisite for short selling) is necessary 19
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