## EXECUTIVE SUMMARY (1hkgea2021001)

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### Overview and recent economic performance
- Hong Kong SAR is a small and open economy and a major international financial center with extensive linkages to Mainland China.
- Over the past two years, Hong Kong SAR experienced unprecedented negative GDP growth, severely impacted by domestic social incidents, US-China tensions, and the global COVID-19 pandemic.
- GDP developments:
  - GDP contracted by 1.2 percent in 2019.
  - GDP declined by 6.1 percent in 2020.
  - Growth is projected to rise to 4.3 percent in 2021.
- Labor market:
  - Unemployment rate rose from 3.3 percent at end-2019 to 6.6 percent at end-2020.
- Policy response:
  - Direct cash transfers, relief grants and loans, Pre-approved Principal Payment Holiday Scheme for eligible SMEs, and enhancements to the SME Financing Guarantee Scheme.
  - Prudential buffer and liquidity measures included reducing the Countercyclical Capital Buffer ratio of banks by 1.5 percentage points and lowering the regulatory reserve requirement on banks by half.

### Main macro-financial vulnerabilities and severe scenario triggers
- Key vulnerabilities:
  - Extensive linkages to Mainland China.
  - Stretched real estate valuations.
  - Exposure to shifts in global market and domestic risk sentiment.
- Potential triggers and severe compounded scenario:
  - Prolonged COVID-19 pandemic.
  - Further slowdown in Mainland China.
  - Sharp rise in global risk-premia compounded by escalating US-China tensions.
  - Sharp housing market correction.
  - In a severe scenario, the four risks above could materialize simultaneously and amplify each other’s effects.

### Stress test findings and sector vulnerabilities
- Banking system resilience and solvency:
  - Banking sector remains well capitalized and profitable; nonperforming loan ratios remain low.
  - Linked Exchange Rate System (LERS) supported by large foreign exchange reserves underpins financial stability.
  - Solvency stress-test headline results:
    - Average CET1 ratio decreases by 4.5 percentage points from 15.9 percent in 2019 to 11.5 percent in 2022 under the severely adverse solvency stress test scenario.
    - IRB banks: CET1 ratio decreases from 16.4 percent in 2019 to 11.7 percent in 2022.
    - Standardized banks: CET1 ratio decreases from 14.4 percent in 2019 to 10.8 percent in 2022.
    - All banks remain above the regulatory minimum of 4.5 percent CET1 ratio plus the capital conservation buffer of 2.5 percent.
- Concentration risk:
  - Assumed default of the five largest exposures in each bank indicates a decline in the average CET1 ratio by close to 6.5 percentage points.
  - Default of all real estate-related borrowers among the top ten large exposures of each bank would lower average CET1 ratio by 2.5 percentage points.
- Liquidity risk:
  - Banking system is resilient to liquidity stress overall, but some foreign branches are more vulnerable due to higher reliance on unsecured interbank funding and inability to tap the local deposit base.
  - Under the most severe FSAP liquidity stress scenario, excess FX reserves are enough to cover more than two times the liquidity needs of Hong Kong SAR banks.
- Non-bank and corporate risks:
  - Non-financial corporate debt-at-risk and default risk could increase significantly under an adverse scenario, particularly in the Mainland China real estate sector.
  - Debt-at-risk definition: share of debt owed by firms with interest coverage ratio (ICR) below 1.
  - Debt-at-risk of Hong Kong SAR- and Mainland China-oriented firms in the adverse scenario would increase to levels beyond their GFC peaks (although still below their AFC peaks), with a more prominent increase in Mainland China-oriented firms.
- Household vulnerability:
  - Low- to median-income households’ mortgage debt service appears vulnerable to income and interest rate shocks.
  - Household bank debt-to-GDP ratio:
    - 51 percent in 2007
    - 88 percent in 2020Q3
  - Selected borrower-level metrics (as of December 2020):
    - Average LTV ratio of new mortgages: 57
    - Mortgage debt service-to-income ratio of new mortgages: 37 percent on average
  - Stress shocks used in household analysis:
    - Interest rate shock: increase in interest rates by 300 bps.
    - Income shock: decline in income by 24 percent.

### Housing market dynamics and valuation risks
- Real residential property prices were nearly 35 percent higher at end-2020 than in early 2014, despite some recent fall in prices in the past two years.
- Office prices declined by 12 percent between end-2018 and end-2020.
- House-at-Risk (HaR) measures (2020Q2):
  - Short-term (one-year) HaR 5% = -3%.
  - Short-term HaR 10% = -6.9%.
  - Three-year ahead HaR 5% = -9.4%.
  - Three-year ahead HaR 10% = -0.8%.
- Counterfactual finding: past IMF research showed that without MPMs and tax measures, house prices would have been 12.5 percent higher, and the mortgage credit-GDP ratio 15 percent higher.

### Macro-financial buffers, markets, and linkages
- FX and fiscal buffers:
  - FX reserves are around 140 percent of GDP, or 1.8 times the monetary base at end-2020.
  - Net international investment position was around 616 percent of GDP at end-2020.
  - Fiscal reserves were about 40 percent of GDP in 2019 and fell to about 33 percent of GDP in December 2020.
- Financial sector scale and market metrics:
  - Banking system assets are about 950 percent of GDP.
  - Life insurance sector life premiums to GDP were about 18 percent in 2019.
  - Hong Kong SAR hosted the world’s fifth largest stock exchange by market capitalization: USD 6.1 trillion at end-2020.
  - Assets under management (AUM) amounted to 1,000 percent of GDP in 2019; non-Hong Kong SAR investors provided 64 percent of AUM in 2019.
  - Mainland China-related lending accounted for close to 40 percent of total bank lending as of September 2020.
  - Nonfinancial corporate debt increased from 202 percent of GDP in 2014 to 257 percent in 2020Q3.
  - Household debt increased from 65 percent to 88 percent over the same period.
  - Domestic credit-to-GDP gap widened from close to zero in 2013 to 35 percent in 2020Q3.

### Fintech, innovation, and climate risks
- Fintech and innovation:
  - Hong Kong SAR actively promotes fintech development; fintech users reached 35 percent in 2018 and consumer fintech adoption rate increased to 67 percent in 2019.
  - Number of fintech companies grew from 230 in 2017 to 600 in 2019.
  - Regulatory actions: Faster Payment System, eight virtual bank and four virtual insurer licenses, open API framework, blockchain-based trade finance platform.
  - Recommendations: harmonize cyber-/IT-related reporting, map network interdependencies, strengthen cross-sector incident reporting consistency, enhance systematic data collection of virtual assets (VA) holdings and trading activities, and increase investor education.
- Climate change:
  - Climate change poses financial stability risks in both the short run and the longer run.
  - Long-term GDP impact: Recent studies indicate climate change may have adverse effects on Hong Kong SAR’s GDP growth in the longer term (up to 6.4 percent deviation from the baseline by 2048).
  - Physical risk findings: insurers’ stock prices and price/book ratios are already adversely affected by physical risk; effect on bank stock prices is small but may reflect mispricing of risk.
  - Transition risk: electricity and gas sector accounts for about 2 percent of the loan book but 65 percent of Hong Kong SAR’s total GHG emissions (40,700 kilotonnes CO2) in 2017.
  - Authorities’ measures: implementation of climate-related mandatory financial disclosures by 2025; adopting common taxonomy; promoting climate-focused scenario analysis through pilot stress testing exercises.

### Financial market infrastructure, CCPs, and AML/CFT
- HKCC assessment and recommendations:
  - HKCC observes PFMI and "has a sound, coherent and transparent legal basis."
  - FSAP recommends establishing an independent risk management committee, enhancing governance (proper HKCC board), HKMA oversight over HKCC for liquidity and settlement risks, and considering consolidation of CCPs for trading.
  - Suggest reviewing resource sufficiency to cover default of the two largest clearing members and strengthening secondary-site arrangements.
- AML/CFT:
  - Hong Kong SAR has a solid regime; FATF 2019 Mutual Evaluation Report found a strong legal and institutional framework.
  - Recommendations: enhance prosecution of laundering of proceeds from foreign offenses; increase risk understanding; strengthen supervision of certain non-financial sectors.
  - Note: proposed "inspection arrangements for companies’ register" may limit public access to certain personal information and could hinder verification of ownership and control of legal persons.

### Institutional frameworks, supervision, and crisis management
- Macroprudential framework and policy stance:
  - MaPP framework is functioning well; current policy stances on real estate and countercyclical capital buffers (CCyB) are appropriate.
  - Need to strengthen systemic risk monitoring, improve data collection (especially intersectoral claims and NBFIs), enhance communication through dedicated financial stability reporting, and bring non-bank mortgage lending within regulatory ambit.
- Microprudential supervision:
  - Banking supervision and regulation are strong; HKMA has updated risk-based supervision and strengthened residential mortgage regulations.
  - Reiterates 2014 FSAP recommendation to provide de jure operational independence to the HKMA; consider specifying circumstances where Chief Executive may give directions to Monetary Authority.
  - IA establishment strengthened insurance regulation; further work needed to implement group-wide supervision and risk-based capital requirements.
  - SFC: strengthen OTC trade surveillance, expand enforcement powers over recognized exchange companies and certain ATS providers.
- Crisis management and safety nets:
  - FIRO (2017) significantly strengthened crisis management arrangements; institution-specific resolution plans under FIRO underway but more work needed.
  - Recommended updates to depositor protection regime:
    - Expand the scope of depositor preference.
    - Extend the mandate of the Deposit Protection Board (DPB) to allow it to contribute to resolution costs.
    - Review the size of the DPS fund and flexibility of levies to ensure consistency with FIRO.
  - Emergency liquidity assistance (ELA) framework updated; legal framework allows use of significant Exchange Fund resources for foreign currency lending.

### Key policy recommendations (selected highlights and timing)
- Strengthening systemic risk monitoring and data collection:
  - Continue to monitor Authorized Institutions’ concentrated exposures to non-bank Mainland China entities, particularly of banking groups with foreign bank branches and subsidiaries. [HKMA] — C
  - Reassess the need for amending the regulatory perimeter to monitor NDFCs and leakages to macroprudential policy. [Hong Kong SAR Authorities] — MT
  - Ensure sufficiently forward-looking internal risk models for capital charge for Mainland China real estate borrowers with low credit ratings. [HKMA] — C
  - Integrate all bank liquidity stress tests, streamline reporting, and enhance monitoring of liquidity position of foreign branches that appear more vulnerable. [HKMA] — MT
  - Integrate monitoring and stress testing of investment funds’ liquidity in the supervisory framework and increase granularity of data collation. [SFC] — MT
  - Monitor non-mortgage household debt; ensure consistency of risk guidelines among regulators on investment credit to high-net-worth individuals. [HKMA/SFC] — ST
- Macroprudential policy framework:
  - Strengthen systemic risk monitoring and data collection framework; continue leveraging analytical expertise of the HKMA/other regulators in CFR/FSC. [FSTB/HKMA/SFC/IA] — ST
  - Enhance data collection of intersectoral claims with a focus on claims of the NBFIs. [FSTB/HKMA/SFC/IA] — ST
- Financial sector supervision and governance:
  - Update legislation to reflect HKMA’s de facto operational independence in the law; in the interim, consider specifying circumstances where Chief Executive may give directions to Monetary Authority. [Government] — MT
  - Implement group-wide supervision and risk-based capital requirements as planned. [IA] — ST
  - Assess systemic risk of individual insurers (potential FIRO designation), and cross-sector risks. [IA] — MT
  - Enhance surveillance and monitoring of OTC trades. [SFC] — MT
  - Expand enforcement powers over recognized exchange companies and clearing houses, and Part III Automated Trading System providers. [SFC] — MT
  - Strengthen the current governance of the HKCC by setting up a proper HKCC board, an independent risk management committee, and decentralized key functions. [HKEX] — ST
- Crisis management and safety nets:
  - Update the deposit protection scheme, including expanding the scope of depositor preference, extending the mandate of the DPB to allow it to contribute to resolution costs, and reviewing the size of the DPS fund and flexibility of levies. [FSTB/HKMA] — MT
- Fintech and financial innovation:
  - Promote consistency and facilitate information sharing across financial sectors with respect to cyber risk supervision; review and compare incident reporting frameworks across sectors and apply best practices to other sectors. [HKMA/SFC/IA] — ST
  - Consider undertaking exercise to map network interdependencies. [HKMA/SFC/IA] — MT
  - Strengthen systematic data collection of entities to enhance monitoring of holdings of virtual assets (VA); monitor VA trading activities continuously; increase investor education. [HKMA/SFC/IA] — ST/C

### Risk Assessment Matrix (selected entries) and authorities’ statement
- Global risks (likelihood / impact as assessed):
  - Unexpected shift in the Covid-19 pandemic — Likelihood: Medium; Impact: Medium.
  - Accelerating de-globalization — Likelihood: Medium; Impact: High.
  - A sharp rise in global risk premia exposing financial and fiscal vulnerabilities — Likelihood: Medium; Impact: High.
- Domestic risks (likelihood / impact as assessed):
  - A further slowdown in Mainland China — Likelihood: Medium; Impact: High.
  - A sharp housing market correction and decline in demand — Likelihood: Medium; Impact: High.
- Authorities’ statement highlights (May 21, 2021):
  - Anti-epidemic Fund (AEF) and other relief measures amount to over HK$300 billion (around US$39 billion), equivalent to about 10-11 percent of GDP.
  - Growth: After contractions of 1.2 percent and 6.1 percent in 2019 and 2020 respectively, real GDP expanded by 7.9 percent year-on-year in Q1 2021. Authorities project real GDP growth in the range of 3.5-5.5 percent for 2021.
  - Reserves and exchange rate regime: Foreign exchange reserves and fiscal reserves stood at 140 percent and 32 percent as of end-2020.
  - Banking health: Total capital adequacy ratio of local banks: 20.7 percent at end-2020; Liquidity coverage ratio: 155.1 percent at end-2020.
  - Household debt: increased to 90.2 percent of GDP in Q4 2020 from 80.4 percent a year earlier; household debt growth moderated to 5.5 percent in 2020 (compared with 12.8 percent in 2019).

### Concluding assessment
- The FSAP finds Hong Kong SAR’s financial system overall robust, supported by sound macroeconomic and prudential policies, a well-capitalized banking sector, and the LERS backed by large foreign exchange reserves.
- Authorities should continue to preserve the rule of law and strengthen the high-quality regulatory framework to maintain competitiveness as a major international financial center.

*Source: EXECUTIVE SUMMARY (1hkgea2021001).*

### EXECUTIVE SUMMARY __________________________________________________________________________________ 7

### EXECUTIVE SUMMARY

### Overview and recent economic performance
- Hong Kong SAR is a small and open economy and a major international financial center with extensive linkages to Mainland China.
- Over the past two years, Hong Kong SAR experienced unprecedented negative GDP growth, severely impacted by domestic social incidents, US-China tensions, and the global COVID-19 pandemic.
- GDP developments:
  - GDP contracted by 1.2 percent in 2019.
  - GDP declined by 6.1 percent in 2020.
  - Growth is projected to rise to 4.3 percent in 2021.
- Labor market:
  - Unemployment rate rose from 3.3 percent at end-2019 to 6.6 percent at end-2020.
- Policy response:
  - Authorities implemented a multi-pronged approach to support the economy and maintain financial stability, including direct cash transfers, relief grants and loans, Pre-approved Principal Payment Holiday Scheme for eligible SMEs, and enhancements to the SME Financing Guarantee Scheme.
  - Prudential buffer and liquidity measures included reducing the Countercyclical Capital Buffer ratio of banks by 1.5 percentage points and lowering the regulatory reserve requirement on banks by half.

### Main macro-financial vulnerabilities and risk scenarios
- Key vulnerabilities:
  - Extensive linkages to Mainland China.
  - Stretched real estate valuations.
  - Exposure to shifts in global market and domestic risk sentiment.
- Potential triggers and severe compounded scenario:
  - Prolonged COVID-19 pandemic.
  - Further slowdown in Mainland China.
  - Sharp rise in global risk-premia compounded by escalating US-China tensions.
  - Sharp housing market correction.
  - In a severe scenario, the four risks above could materialize simultaneously and amplify each other’s effects.

### Stress test findings and sector vulnerabilities
- Banking system resilience:
  - Banking sector remains well capitalized and profitable; nonperforming loan ratios remain low.
  - Linked Exchange Rate System (LERS) supported by large foreign exchange reserves underpins financial stability.
- Solvency stress test:
  - Under a severely adverse solvency stress test scenario combining the four risk factors, banks’ average common equity tier 1 capital (CET 1) ratio decreases by 4.5 percentage points from 15.9 percent in 2019 to 11.5 percent in 2022—remaining well above regulatory requirements.
- Concentration risk:
  - Assessment based on assumed default of the five largest exposures in each bank indicates a decline in the average CET1 ratio by close to 6.5 percentage points.
- Liquidity risk:
  - Banking system is resilient to liquidity stress overall, but some foreign branches are more vulnerable due to higher reliance on unsecured interbank funding and inability to tap the local deposit base.
  - Recommendation to integrate all bank liquidity stress tests, streamline reporting, and enhance monitoring of liquidity at foreign branches.
- Non-bank and corporate risks:
  - Non-financial corporate debt-at-risk and default risk could increase significantly under an adverse scenario, particularly in the Mainland China real estate sector.
  - Low- to median-income households’ mortgage debt service appears vulnerable to income and interest rate shocks.
- Investment funds:
  - Recommend integrating monitoring and stress testing of investment funds’ liquidity in the supervisory framework and increasing data granularity.

### Institutional frameworks and supervisory assessments
- Macroprudential framework and policy stance:
  - Institutional MaPP framework is functioning well; current policy stances on real estate and countercyclical capital buffers (CCyB) are appropriate.
  - Scope for strengthening systemic risk monitoring, improving data collection, enhancing communication through a comprehensive and dedicated financial stability report, and bringing non-bank mortgage lending within the regulatory ambit.
- Microprudential supervision:
  - Banking supervision and regulation are strong, including on cross-border linkages and housing risks.
  - Reiterates the 2014 FSAP recommendation to provide de jure operational independence to the Hong Kong Monetary Authority (HKMA) and to adopt a framework to ensure the prudential mandate is not compromised by development initiatives.
  - The establishment of the Insurance Authority (IA) has greatly strengthened insurance regulation and supervision of insurers and intermediaries.
  - Securities markets: regulatory and supervisory framework for trading systems has been strengthened since the 2014 FSAP, including supervisory coordination with the Mainland.
- Crisis management, resolution, and safety nets:
  - Introduction of the Financial Institutions Resolution Ordinance (FIRO) in 2017 significantly strengthened crisis management arrangements.
  - HKMA and other resolution authorities have begun implementing institution-specific resolution plans under FIRO, though more work is needed.
  - Recommended updates to depositor protection regime:
    - Expand the scope of depositor preference.
    - Extend the mandate of the Deposit Protection Board (DPB) to allow it to contribute to resolution costs.
    - Review the size of the DPS fund and flexibility of levies to ensure consistency with FIRO and underpin deposit confidence.
- Financial Market Infrastructure:
  - HKFE Clearing Corporation Limited (HKCC) has a sound legal basis and comprehensive risk management framework, but governance structure and risk management can be further enhanced; an independent review has been commenced.

### Fintech, innovation, and climate risks
- Fintech:
  - Authorities actively promote Hong Kong SAR as a fintech hub.
  - Continued coordinated efforts among regulators recommended to harmonize frameworks for cyber-/IT-related reporting, artificial intelligence and RegTech adoption, and cyber mapping.
  - Recommend mapping network interdependencies and strengthening cross-sector incident reporting consistency.
  - Enhance systematic data collection to monitor virtual assets (VA) holdings and trading activities and increase investor education.
- Climate change:
  - Climate change poses financial stability risks in both the short run and the longer run.
  - FSAP welcomes authorities’ plans for mandatory disclosures, Common Ground Taxonomy, and risk assessments.

### Key recommendations (selected highlights and timing)
- Strengthening systemic risk monitoring:
  - Continue to monitor Authorized Institutions’ concentrated exposures to non-bank Mainland China entities, particularly of banking groups with foreign bank branches and subsidiaries. [HKMA] — C
  - Reassess the need for amending the regulatory perimeter to monitor NDFCs and leakages to macroprudential policy. [Hong Kong SAR Authorities] — MT
  - Ensure sufficiently forward-looking internal risk models for capital charge for Mainland China real estate borrowers with low credit ratings. [HKMA] — C
  - Integrate all bank liquidity stress tests, streamline reporting, and enhance monitoring of liquidity position of foreign branches that appear more vulnerable. [HKMA] — MT
  - Integrate monitoring and stress testing of investment funds’ liquidity in the supervisory framework and increase granularity of data collation. [SFC] — MT
  - Monitor non-mortgage household debt; ensure consistency of risk guidelines among regulators on investment credit to high-net-worth individuals. [HKMA/SFC] — ST
- Macroprudential policy framework:
  - Strengthen systemic risk monitoring and data collection framework; continue leveraging analytical expertise of the HKMA/other regulators in CFR/FSC. [FSTB/HKMA/SFC/IA] — ST
  - Enhance data collection of intersectoral claims with a focus on claims of the NBFIs. [FSTB/HKMA/SFC/IA] — ST
- Financial sector supervision:
  - Update legislation to reflect HKMA’s de facto operational independence in the law; in the interim, consider specifying circumstances where Chief Executive may give directions to Monetary Authority. [Government] — MT
  - Implement group-wide supervision and risk-based capital requirements as planned. [IA] — ST
  - Assess systemic risk of individual insurers (potential FIRO designation), and cross-sector risks. [IA] — MT
  - Enhance surveillance and monitoring of OTC trades. [SFC] — MT
  - Expand enforcement powers over recognized exchange companies and clearing houses, and Part III Automated Trading System providers. [SFC] — MT
  - Strengthen the current governance of the HKCC by setting up a proper HKCC board, an independent risk management committee, and decentralized key functions. [HKEX] — ST
- Crisis management and financial safety nets:
  - Update the deposit protection scheme, including expanding the scope of depositor preference, extending the mandate of the DPB to allow it to contribute to resolution costs, and reviewing the size of the DPS fund and flexibility of levies. [FSTB/HKMA] — MT
- Fintech and financial innovation:
  - Promote consistency and facilitate information sharing across financial sectors with respect to cyber risk supervision; review and compare incident reporting frameworks across sectors and apply best practices to other sectors. [HKMA/SFC/IA] — ST
  - Consider undertaking exercise to map network interdependencies. [HKMA/SFC/IA] — MT
  - Strengthen systematic data collection of entities to enhance monitoring of holdings of virtual assets (VA); monitor VA trading activities continuously; increase investor education. [HKMA/SFC/IA] — ST/C

### Concluding assessment
- The FSAP finds Hong Kong SAR’s financial system overall robust, supported by sound macroeconomic and prudential policies, a well-capitalized banking sector, and the LERS backed by large foreign exchange reserves.
- Authorities should continue to preserve the rule of law and strengthen the high-quality regulatory framework to maintain competitiveness as a major international financial center.

*Source: EXECUTIVE SUMMARY (1hkgea2021001).*

### 2.      Fueled by strong demand and a chronic shortage in housing supply, real residential

### 1hkgea2021001 - 2.      Fueled by strong demand and a chronic shortage in housing supply, real residential

### Housing market dynamics and policy responses
- Real residential property prices were nearly 35 percent higher at end-2020 than in early 2014, despite some recent fall in prices in the past two years.
- Office prices declined by 12 percent between end-2018 and end-2020, largely attributed to the economic slowdown and adoption of work-from-home measures amidst the pandemic.
- Macroprudential policy measures (MPMs) tightened by the HKMA included limits on total debt servicing ratios and loan-to-value (LTV) ratios for mortgages, which helped contain banks’ exposure to the housing boom.
- Government measures to contain speculative activity and external demand included increased stamp duties and other taxation measures.
- To complement MPMs, the government adopted supply-side measures to boost housing supply (see the Hong Kong SAR’s 2019 Art. IV report for more details).
- In response to the slipping non-residential property market, in August 2020 the HKMA adjusted the LTV caps for mortgage loans on non-residential properties upward by 10 percentage points.
- Past IMF research showed that without MPMs and tax measures, house prices would have been 12.5 percent higher, and the mortgage credit-GDP ratio 15 percent higher (IMF Country Report 18/17).

### Debt, leverage, and credit gaps
- Bank credit growth slowed to 7 percent (y/y) in the first three quarters of 2020 and to 1.2 percent in 2020.
- Bank credit growth peaked at 16 percent in 2017.
- Mainland China-related lending accounted for close to 40 percent of total bank lending as of September 2020.
- Nonfinancial corporate (NFC) debt increased from 202 percent of GDP in 2014 to 257 percent in 2020Q3.
- Household debt increased from 65 percent to 88 percent over the same period.
- The domestic credit-to-GDP gap widened from close to zero in 2013 to 35 percent in 2020Q3.
- Debt-at-risk for NFCs remained low from a historical perspective (Figure 3).
- Non-deposit taking finance companies (NDFC) lending was estimated at about 5 percent of GDP in 2019; property developers extended mortgage loans of HKD 41bn with LTV ratios up to 90 percent (equivalent to 3 percent of outstanding residential mortgages of AIs) based on June 2019 figures.

### Macro-financial buffers and resilience
- FX reserves are around 140 percent of GDP, or 1.8 times the monetary base at end-2020.
- Net international investment position was around 616 percent of GDP at end-2020.
- Fiscal reserves were about 40 percent of GDP in 2019 and fell to about 33 percent of GDP in December 2020 due to countercyclical fiscal policy measures.
- Banking sector metrics as of 2020Q3 and 2020 Q1-Q3:
  - Tier 1 capital ratio: 18.3 percent.
  - Liquidity coverage ratio: 157 percent.
  - Nonperforming loans (NPL) ratio: 0.8 percent (2020Q3).
  - Return on assets has remained around 1 percent since 2013 but fell to 0.8 percent (annualized) during 2020 Q1-Q3.

### Financial sector landscape and market linkages
- Banking system assets are about 950 percent of GDP.
- Life insurance sector life premiums to GDP were about 18 percent in 2019.
- Hong Kong SAR hosted the world’s fifth largest stock exchange by market capitalization: USD 6.1 trillion at end-2020.
  - Mainland China-related companies accounted for around half of listed companies, representing 81 percent of total capitalization.
- USD-denominated bond issuance in Hong Kong SAR by Mainland China firms accounted for more than 60 percent of Mainland China firms’ total offshore issuances in 2020.
- Stock Connect 2020 average daily turnover: Northbound traffic up by 119 percent; Southbound traffic up by 128 percent.
- Bond Connect average daily turnover increased by 82 percent in 2020 on top of a tripling in 2019.
- Assets under management (AUM) amounted to 1,000 percent of GDP in 2019.
  - Non-Hong Kong SAR investors provided 64 percent of AUM in 2019.
  - Assets managed in Hong Kong SAR made up 56 percent of AUM.
  - 387 licensed corporations and registered institutions established by Mainland China-related groups were active in Hong Kong SAR (up by 7 percent from 2018).
- Hong Kong SAR’s FX swap market is the largest in Asia.
- Local banks vs. foreign branches:
  - Local banks: significant local deposit funding, significant portion of Mainland China-related loans (about one-third of their loans); approximately 30 percent of their non-bank lending to households.
  - Foreign branches: rely more on the interbank market and corporate deposits; lend mostly to corporates (many located outside Hong Kong SAR); foreign branches are not allowed to lend to retail borrowers beyond a minimal limit.
  - About 52 percent of foreign branches’ lending are Mainland China-related, compared to around one third for local banks.
  - Foreign branches account for 60 percent of total cross-border interbank claims.
  - Foreign branches account for under 39 percent of total assets of Hong Kong SAR office-only balance sheets of all banks.

### Key vulnerabilities and systemic risks
- Principal vulnerabilities: extensive Mainland China linkages, stretched real estate valuations, and exposure to shifts in global market and domestic risk sentiment.
- Key risks identified by the FSAP:
  - A prolonged COVID-19 pandemic could reduce both domestic and external economic activity and prevent a speedy recovery.
  - Accelerating de-globalization and heightened protectionism accompanied by a further slowdown in Mainland China could lead to higher uncertainty, reduce trade flows through Hong Kong SAR and lead to a sharp decline in economic activity.
  - A sharp rise in global risk premia compounded by escalating US-China tensions could tighten financial conditions in Hong Kong SAR and cause repricing of Hong Kong SAR-specific risks, leading to capital outflows, higher funding cost for borrowers and lower asset values, including property prices.
  - A sharp housing market correction and decline in demand could lower confidence and residential investment, constrain new bank lending and lead to a larger downturn.
- Any renewed social incidents, global economic uncertainties and US-China tensions could challenge Hong Kong SAR’s standing as an international financial center and could trigger a house price correction, amplifying downturns via falling house prices, weaker consumption, higher NPLs, and tighter lending standards.

### House price valuation and House-at-Risk (HaR) analysis
- Panel results and measures (2020Q2):
  - Short-term (one-year) HaR 5th percentile (compounded growth): HaR 5% = -3%.
  - Short-term HaR 10th percentile: HaR 10% = -6.9%.
  - Three-year ahead HaR 5th percentile (compounded growth): HaR 5% = -9.4%.
  - Three-year ahead HaR 10th percentile: HaR 10% = -0.8%.
- Factors affecting House Prices at Risk (statistically significant at the 10 percent level where colored bars indicate significance) include: house price growth (lag), GDP growth, Price-to-GDP per capita (misalignment), population growth, real residential investment growth, financial conditions index, household debt-to-GDP growth.
- Counterfactual adverse scenario for HaR is calibrated as simultaneous standard deviation shocks to: house-prices-to-GDP per capita ratio (misalignment), financial conditions index and credit to household-to-GDP ratio.

### Stress testing and scenario design
- Bank solvency test covers the 11 largest locally incorporated banks (93 percent of local banks’ assets) using 2019 data.
- Liquidity tests examine 12 local banks and 11 foreign branches using 2020 Q2 data.
- Solvency exercise is conservative and does not incorporate potential positive impact of temporary borrower support policies (e.g., income support to households and SMEs, loan principal payment deferrals).
- Liquidity stress tests used December 2018 and June 2020 data for comparison.
- Investment fund stress tests examined redemption risk profiles.
- Household sector tests assess mortgage repayment capacity by income groups.
- NFC tests assess effects of adverse macroeconomic scenarios on debt-servicing capacity and default risk.
- The mission also assessed physical risks from climate change and the transition risk from the discontinuation of LIBOR as a reference rate by end-2021.
- Macroeconomic adverse scenario:
  - The GDP path is more severe than the AFC throughout the simulation period (2020-2022).
  - Policy rates are assumed to remain accommodative.
  - Financial conditions tighten significantly as corporate credit spreads rise and asset prices fall, amplifying effects on the banking system.
  - Adequacy of the stress scenario for GDP is corroborated by the Growth-at-Risk (GaR) model.

*IMF staff report: PEOPLE’S REPUBLIC OF CHINA—HONG KONG SAR, excerpted chapter content.*

### 13.      Household debt has grown rapidly

### 13.      Household debt has grown rapidly

### Household debt trends and composition
- Household bank debt components: residential mortgage, credit card debt, and other investment-related debt.
- Household bank debt-to-GDP ratio:
  - 51 percent in 2007
  - 88 percent in 2020Q3
  - Compared with 72 percent average for advanced economies.
- If non-bank lending to households (e.g., consumer finance companies, property developers) is included, household debt-to-GDP ratio could be at least 3-5 percentage points higher.
- BIS data shows the annual increase of household debt-to-GDP ratio is among the highest in advanced economies.

### Household vulnerability and buffers
- Macroprudential tightening by HKMA has kept credit quality of household mortgage on sound footing on average.
- Selected borrower-level metrics (as of December 2020):
  - Average LTV ratio of new mortgages: 57
  - Mortgage debt service-to-income ratio of new mortgages: 37 percent on average
- Household balance-sheet buffers (2019):
  - Household net worth-to-liabilities ratio: 11.2
  - Safe assets-to-liabilities ratio: 2.88
- Distributional concern:
  - Wealth distribution likely skewed towards higher-income households.
  - Lower and medium-income households already have high debt service ratios (DSRs) that would increase significantly under severe stress (combined 300 basis point interest rate hike with an income shock).

### Stress scenarios, GaR model results, and shock definitions
- GDP growth scenarios (baseline and adverse) referenced; adverse scenario assumptions:
  - The adverse scenario GDP growth assumption in 2020 has a 3.8 percent probability in the growth-at-risk model.
  - The assumed adverse GDP growth for 2021 is an 11.4-percentile tail event based on the model.
- Shock definitions used in household debt service analysis:
  - Interest rate shock: increase in interest rates by 300 bps.
  - Income shock: decline in income by 24 percent (equivalent to 1 standard deviation of consolidated medium monthly payment figures over 1985-2020).
- Debt service ratios presented in percent of gross monthly income per borrower; portfolio includes HKD loans only; mortgages approved on net worth basis and mortgages where borrower income is not reported are excluded.

### Corporate and market spillovers affecting household risk
- Under an adverse scenario, corporate debt-at-risk and default risk could increase significantly, particularly in the Mainland China real estate sector.
- Debt-at-risk definition: share of debt owed by firms with interest coverage ratio (ICR) below 1.
- Key findings on corporate exposures:
  - Debt-at-risk of Hong Kong SAR- and Mainland China-oriented firms in the adverse scenario would increase to levels beyond their GFC peaks (although still below their AFC peaks), with a more prominent increase in Mainland China-oriented firms.
  - Debt-at-risk in the Mainland China-oriented real estate sector is particularly vulnerable to the adverse shocks.
  - Median probability of default (PD) across all firms could increase significantly in the adverse scenario although still below their AFC peaks; PDs of Mainland China-oriented real estate sector are most vulnerable.
- Offshore bond issuance:
  - About 20 percent of the total amount issued is by Mainland China real estate developers.
  - High-yield issuances are mostly from onshore property developers and denominated in RMB.
  - Potential currency mismatch and refinance risks could spill over to Hong Kong SAR banks via common exposure, margin finance and market-making obligations.
- Firm sample and aggregation note:
  - Total number of firms about 2,000.
  - Total debt of firms domiciled in Hong Kong SAR accounted for nearly 90 percent of Hong Kong SAR’s total non-financial corporate debt in 2019 (or about 200 percent of Hong Kong SAR’s GDP).

### Bank solvency and concentration risks from household and corporate stress
- Bank solvency stress test headline results:
  - Average CET1 ratio decreases from 15.9 percent in 2019 to 11.5 percent in 2022 under the adverse scenario.
  - IRB banks: CET1 ratio decreases from 16.4 percent in 2019 to 11.7 percent in 2022 (decline of 4.6 percentage points).
  - Standardized banks: CET1 ratio decreases from 14.4 percent in 2019 to 10.8 percent in 2022.
  - Even with these declines, all banks remain above the regulatory minimum of 4.5 percent CET1 ratio plus the capital conservation buffer of 2.5 percent.
- Main drivers of capital decline in the adverse scenario:
  - Loan loss provisions (credit losses)
  - Increase in risk-weighted assets (RWA)
  - Decline in net interest margins (interest rate risk)
- Concentration risk sensitivity:
  - Default of the five largest NFC exposures in each bank would lower average CET1 ratio by close to 6.5 percentage points.
  - Default of all real estate-related borrowers among the top ten large exposures of each bank would lower average CET1 ratio by 2.5 percentage points.
  - Large exposures to sectors heavily affected by COVID-19 (transportation, hotels, recreational activities) are much smaller and would pose minimal losses for the analyzed banks.
- Modeling assumptions in concentration analysis:
  - Zero recovery on the unsecured part of the exposure and full recovery of the value of available collateral.

### Liquidity resilience and FX reserve buffers
- Cashflow-based liquidity stress tests show local banks had enough liquid assets to cover stressed cash outflows; foreign branches are more vulnerable due to higher reliance on unsecured interbank funding and inability to tap local deposit base.
- Banks rely on well-functioning FX swap markets for USD and CNH liquidity, exposing them to some tail risk.
- Excess FX reserves provide significant buffers:
  - Under the most severe FSAP liquidity stress scenario, excess FX reserves are enough to cover more than two times the liquidity needs of Hong Kong SAR banks.
  - Under assumption of large capital outflows, current HKMA reserves and LERS mechanism would lead to only limited HKD rate increases and not adversely affect solvency resilience of the banking system.
- Authorities actively communicated that liquidity buffers are designed to be used under stress and complemented these with systemic liquidity measures.

### Interconnectedness and data gaps
- Foreign branches may be a source of significant spillovers domestically and abroad: they source funding from local banks and lend to NBFIs and other banking systems abroad.
- Indirect linkages can create leakages that reduce the effectiveness of regulations aimed at mitigating build-up of risks (e.g., capital-based regulations on bank lending to certain nonfinancial corporates).
- Data gaps: lack of complete who-to-whom exposures across banking, NBFIs, NFCs, households, government, and rest of world limits identification of potential stability risks originating outside the banking system.

### FSAP policy recommendations (focused on household, corporate, and banking vulnerabilities)
- Continue close monitoring of credit risks facing potential high-risk Mainland China borrowers.
- Ensure internal risk models used to determine capital charges for these borrowers, particularly Mainland China real estate borrowers with low credit ratings, are sufficiently forward-looking.
- Consider incorporating non-financial corporates in the stress testing framework and communicate key findings in HKMA’s Monetary and Financial Stability Reports.
- Enhance HKMA’s data collection of intersectoral claims across major sectors (banking, NBFIs, non-financial corporates, households, government, and rest of the world) with focus on claims of the NBFI sector to develop an aggregate balance sheet approach in systemic risk assessment.
- Strengthen oversight over banking groups that have both foreign branches and local subsidiaries in Hong Kong SAR to improve monitoring and mitigation of contagion risks.
- Heighten monitoring of liquidity risk both at group and entity level for banks operating multiple group entities in Hong Kong SAR to ensure adherence to internal risk management practices.
- Periodically stress test banks’ large exposures separately from their total loan books, considering potential cash flows from collateral in case of default of large borrowers.

*Source: IMF staff calculations.*

### 25.      To further strengthen HKMA’s liquidity reporting and stress testing framework, the

### 1hkgea2021001 - 25.      To further strengthen HKMA’s liquidity reporting and stress testing framework, the

### Liquidity reporting and funding recommendations
- Recommend integrating all existing liquidity stress-tests into a single framework and align that with the LCR.
- Medium-term recommendation: develop alternative funding sources for banks.
- Observed funding structure: Hong Kong SAR banking system is currently mostly funded by very short-term deposits.
- Suggested measures: develop the repo market and take measures to incentivize banks to diversify funding sources and lengthen and stagger funding tenors.

### Investment Fund Liquidity Stress Tests
- FSAP assessment: large sales by investment funds from large redemption shocks are unlikely to substantially affect asset prices.
- Observation: Investment funds domiciled in Hong Kong SAR display higher cash buffers and are better protected against extreme redemption shocks than funds merely marketing products in Hong Kong SAR.
- Vulnerable segments: funds with shares denominated in foreign currencies; smaller funds; fixed-income funds; funds geared towards riskier asset markets — these appear more prone to liquidity stress.
- Regulatory mitigation: The SFC requires fund managers to implement adequate liquidity risk management policies and procedures, assess liquidity profile of funds’ liabilities and assets, and conduct formal liquidity stress tests on a regular basis; the SFC reviews compliance during inspections.
- Residual risk: Some residual liquidity risks remain under the severe scenario of funds experiencing the worst percentile of their historical outflows, but they are unlikely to affect asset prices substantively.

### Climate change risk analysis
- Climate risks identified: physical (event risk) and transition effects.
- Long-term GDP impact: Recent studies indicate climate change may have adverse effects on Hong Kong SAR’s GDP growth in the longer term (up to 6.4 percent deviation from the baseline by 2048).
- Channels of impact: higher temperatures, rising sea level, greater health risks, declining tourism, destruction of fixed capital, and lower productivity.
- Historical impacts found by FSAP:
  - Hong Kong SAR insurers’ stock prices and price/book ratios are already adversely affected by physical risk (notably storms, floods and landslides).
  - Effect on Hong Kong SAR bank stock prices is small (profits and capital buffers not much affected), though this may reflect mispricing of risk.
  - Over the period 1998-2019, Hong Kong SAR stocks of companies highly sensitive to temperature anomalies earned significantly lower returns, indicating mispricing of climate risk.
- Future risk: If global efforts to reduce GHG emissions fall short, climate risk will intensify and adverse effects on banks, insurers and nonfinancial firms could increase in a nonlinear way.
- Authorities’ measures:
  - Implementation of climate-related mandatory financial disclosures by 2025.
  - Adopting common taxonomy.
  - Promoting climate-focused scenario analysis through pilot stress testing exercises for banks and insurance companies, and use of scenario analysis by large asset managers.
- FSAP emphasis: incorporate climate risk into systemic risk analysis.

### Macroprudential framework and oversight — Framework
- MaPP institutional assessment: framework is functioning well and has supported financial stability, particularly in the context of rising house prices and strengthening capital buffers in the banking sector.
- Regulatory structure: sector-based across three regulators (HKMA, SFC, and IA) with coordination via Council of Financial Regulators (CFR) and Financial Stability Committee (FSC).
- Data sharing: frequent and formalized by Memoranda of Understanding (MoU).
- Areas for improvement:
  - Adopt a more comprehensive and systematic approach to identify and address financial systemic risk by leveraging organizational framework and expertise of the HKMA and other regulators.
  - Collect more comprehensive and granular data on cross-border exposures (example: non-bank lending to households, developments in the high yield bond market) to improve systemic risk monitoring.
  - Enhance communication of MaPP by publishing periodic risk assessments and summaries of key CFR policy meetings, and dedicated reports on financial systemic risks.
  - Regular surveillance and data collection from non-bank lenders (e.g., property developers and NDFCs) to households should be strengthened to monitor and stem leakages in macroprudential policies.

### Macroprudential framework and oversight — Policy stance
- FSAP view: current policy stance on systemic risks from residential and commercial real estate and on CCyB is appropriate.
- Specific points:
  - Three-pronged approach to contain residential housing market risks and improve affordability remains appropriate.
  - Despite weak economic activity since 2019, resiliency of house prices and mortgage growth implies existing residential housing market-related MPMs should be kept unchanged for now; nonresidential measures can be relaxed.
  - Need for regular surveillance over non-bank financial sector to stem policy leakages.
  - As CRE prices have fallen, overvaluation risks decreased; HKMA increased LTV caps from 40 to 50 percent in general cases — FSAP endorses this.
  - CCyB was cut twice from 2.5 percent in 2019 to 1 percent in March 2020 to encourage overall bank lending to support the economy.

### Microprudential supervision — Banking supervision
- Assessment: HKMA’s banking supervision and regulation remains strong, upholding high standards from the 2014 Basel Core Principles assessment.
- Actions taken:
  - Updated risk-based supervisory approach.
  - Strengthened regulation of residential mortgage lending.
  - Raised risk-weight floors on residential mortgage loans and raised risk weights for credit exposures to property developers offering high LTV mortgages.
  - Thematic examinations of lending to property developers in 2017-2018.
- NDFCs (non-deposit taking finance companies):
  - Regulated under the Money Lenders Ordinance and licensed by the Licensing Court rather than sectoral financial regulators.
  - Scale currently modest; lending by money lenders estimated at less than 1 percent of total bank loans.
  - HKMA should monitor whether macroprudential policies have spurred household exposures to NDFCs and property developers; adjusting regulatory parameters may be needed for timely risk recognition.
- Cross-border linkages:
  - HKMA strengthened home-host coordination with home supervisors of international banks and with Mainland China regulators.
  - Continue to monitor concentrated exposures to non-bank Mainland China entities, especially for banking groups with both foreign bank branches and subsidiaries in Hong Kong SAR, with focus on potential regulatory arbitrage.
- Cross-sector linkages:
  - Cooperation among HKMA and other regulators is extensive; MoUs are effective.
  - Enhance information sharing mechanisms given growing linkages; continue joint examinations proactively for cross-sectoral business.
- Further priorities and recommendations:
  - Ensure regulations support innovation (e.g., Smart Banking) and strengthen cyber resilience of banks.
  - Review individuals holding a large number of director/management positions for conflicts of interest and time commitment.
  - Closely monitor exempted exposures from the large exposure rules and consider limited on-site examination of large foreign bank branches that lack recent onsite presence.
  - Strengthen framework for use of external auditors to manage supervisory objectivity risk.
  - Continued attention to supervisory resources and competing priorities.

### Microprudential supervision — Governance and independence
- FSAP reiteration: provide de jure operational independence to the HKMA (as recommended in 2014 FSAP) and review checks and balances to ensure prudential mandate is not undermined by developmental initiatives.
- Legal context: Banking Ordinance gives the Chief Executive (CE) of Hong Kong SAR a reserve power to give directions to the Monetary Authority (MA) and the MA shall comply with any direction given.
- Observations and recommendation:
  - The reserve power has never been invoked and any exercise would be limited to furthering BO objectives, but its existence may undermine de jure operational independence.
  - It would be desirable to remove or clarify this power by specifying circumstances under which the CE may give directions to the MA.
  - Maintain distinct legal status of Hong Kong SAR by upholding transparent rules and judicial independence as a precondition for effective banking supervision.

### Microprudential supervision — Insurance supervision
- IA establishment: strengthened insurance regulation; IA supervises insurers (since June 2017) and intermediaries (since September 2019) with extended powers, including resolution authority and control over staff salaries and use of its resources.
- Staffing: recruited more staff with industry experience, including actuaries.
- Remaining issues:
  - Some provisions from previous legislation that could compromise independence were carried over; IA remains dependent on government for certain regulations and budgetary approval.
  - Mitigants: clear statutory objectives and close collaboration with government.
- Recommendations for IA development:
  - Complete reform of insurance regulation, including implementation of full group-wide supervision and risk-based capital requirements, and intermediaries’ supervision — this will take several years.
  - Develop and document internal IA processes for supervision and enforcement, with appropriate publication of key features.
  - Further develop capacity to identify and respond to sector risks, including vulnerability of many long-term insurers to prolonged low interest rates, increased incidence of typhoons, and broader climate change risks.

### Microprudential supervision — Securities markets supervision
- Progress since 2014 FSAP:
  - Strengthened regulatory and supervisory framework for trading systems.
  - Consolidated requirements for ATS into guidelines and code of conduct amendments.
  - SFC now carries out regular on-site inspections of recognized exchanges and clearing houses.
  - Supervision of ATS provision by intermediaries revamped with a more intrusive and risk-based approach.
  - Expanded cooperation with China Securities Regulatory Commission (CSRC) via cooperation agreements and more frequent formal and informal exchanges.
- Recommendations:
  - SFC should continue strengthening the regulatory and supervisory framework for trading systems, including expanding enforcement powers in relation to recognized exchange companies and certain ATS providers.
  - Fine-tune market surveillance to access a more comprehensive range of trading data.
  - Consider consolidating requirements for recognized exchange companies into the regulatory framework.
  - Ensure continued strengthening of cooperation with Mainland China as market ties intensify.

*Source: IMF staff compilation from the provided content unit.*

### 39.      A detailed assessment of the systemically important HKCC, one of four central

### A detailed assessment of the systemically important HKCC, one of four central counterparties (CCPs) in Hong Kong SAR

### HKCC assessment and risk management findings
- HKCC observes the CPSS-IOSCO principles for financial market infrastructures (PFMI) and "has a sound, coherent and transparent legal basis."
- Credit and liquidity risks are minimized by:
  - a robust risk management framework,
  - a rigorous stress testing methodology,
  - access to qualifying liquid resources.
- HKCC has clear rules and procedures to handle and manage a participant’s default procedures.
- HKCC has established a risk management framework to handle operational risk, including cyber risk, and business continuity management that addresses events posing significant risk of operational disruption.
- The four CCPs referenced are: HKCC, Hong Kong Securities Clearing Company Limited (HKSCC), the SEHK Options Clearing House Limited (SEOCH), and OTC Clearing Hong Kong Limited (OTC Clear).

### Governance and further risk-management enhancements (FSAP recommendations)
- Need for further enhancement of the risk management framework and governance structure.
- FSAP recommends:
  - establishing an independent risk management committee for HKCC’s clearing activities (a review of governance by an independent consultant has since commenced);
  - HKMA oversight over HKCC for liquidity and settlement risks;
  - consolidating the three central counterparties (CCPs) for trading into a single CCP, duly considering the cost and benefit and timing, with an appropriate governance structure, an independent board, key functionalities and decision-making process.
- Additional recommendations:
  - HKCC could review the need for strengthening resources to cover the default of the two largest clearing members.
  - Strengthening the secondary site with appropriate staffing arrangements, sufficient resources, capabilities, and functionalities, to allow swaps of operations between the primary and secondary sites during business-as-usual.

### Financial integrity (AML/CTF)
- Hong Kong SAR has a solid regime to fight money laundering and terrorist financing (ML/TF) that is delivering good results.
- The Financial Action Task Force (FATF)’s 2019 Mutual Evaluation Report found:
  - Hong Kong SAR has a strong legal and institutional framework;
  - the authorities generally have a good understanding of the ML/TF risks they are exposed to, as do the larger financial sector entities.
- Authorities have been actively prosecuting ML from domestic offenses.
- Recommended actions from the Mutual Evaluation Report to pursue:
  - enhancing prosecution of the laundering of proceeds from foreign offenses;
  - increasing risk understanding;
  - strengthening supervision of certain non-financial sectors (such as trust and company service providers and legal and accounting professionals).
- Note: proposed "inspection arrangements for companies’ register" may limit public access to certain personal information related to directors of companies and could make verification of ownership and control of legal persons more difficult, potentially undermining the effectiveness of AML/CFT measures.

### Fintech and financial innovation: development and metrics
- Hong Kong SAR has a high digital penetration rate similar to major regional peers.
- Key data points:
  - In 2018, Hong Kong SAR ranked fifth in digitalization of the traditional financial sector.
  - The percentage of fintech users reached 35 percent in 2018.
  - In 2019, the consumer fintech adoption rate increased to 67 percent.
  - The number of fintech companies grew from 230 in 2017 to 600 in 2019.
  - Sandboxes: aggregated products tested grew from 29 products in 2017 to 103 in 2019.
- Important milestones since 2016 include:
  - the launch of the Faster Payment System;
  - the granting of eight virtual bank and four virtual insurer licenses;
  - the adoption of the open API framework by banks;
  - the creation of a blockchain-based trade finance platform.
- HKMA and other regulators’ initiatives:
  - HKMA created the Fintech Facilitation Office.
  - HKMA launched "Smart Banking" initiatives and developed a RegTech promotion roadmap.
  - Regulators introduced and refined supervisory requirements, including a voluntary framework for Virtual Asset (VA) trading platforms and guidance for intermediaries dealing with VAs.
- Policy guidance:
  - Close supervision of initial operations and comprehensive assessments on virtual banks’ medium- to long-term viability will be critical before additional licenses are granted.
  - Continued coordination among regulators is encouraged to guide a more consistent and cross-sectoral approach.
  - Increased reliance on third-party technology service providers and deeper engagement between fintech companies and financial institutions may necessitate methodologies to recognize interconnectedness and concentration risk (e.g., mapping network interdependencies in the financial sector).
  - Frameworks that would benefit from a more holistic activities-based approach include cyber/IT related incident reporting, information sharing, and the implications of artificial intelligence/regtech adoption.
  - Continued review of the regulatory perimeter of non-bank fintech companies is warranted.
  - Authorities are encouraged to continue closely monitoring virtual assets (VAs) including negotiation of these instruments via trading platforms, financial institutions’ exposure to VAs, and to mitigate the risk of misuse by criminals.

### Crisis management, resolution, and safety nets
- The framework for crisis management has been strengthened following the 2014 FSAP and is now "broadly adequate."
- The 2017 Financial Institutions Resolution Ordinance (FIRO) created a regime that is clear, comprehensive, and closely aligned with the Financial Stability Board (FSB) Key Attributes of Effective Resolution Regimes, with particularly strong cross-sectoral coverage.
- The HKMA’s detailed rules and guidance issued under FIRO are broadly in line with international good practice, despite scope for some enhancements and delays to planned consultations on additional rules during 2020.
- The framework for emergency liquidity assistance (ELA) in HKD has been updated; the legal framework allows use of significant Exchange Fund resources for foreign currency lending.
- FSAP recommendations include:
  - Enhancing implementation of the resolution framework in several areas, including:
    - resolution planning for non-DSIBs;
    - close monitoring of Loss-Absorbing Capacity, especially where the HKMA’s LAC requirements come into force earlier than group-level TLAC requirements;
    - ex-post resolution levies;
    - adequate resourcing of nonbank resolution authorities (particularly for CCPs);
    - strengthening cross-border cooperation, information sharing, and simulation exercises, in particular with Mainland China and other resolution authorities in the region.
  - Providing greater clarification on governance and risk management of ELA, including on HKMA’s approach to viability assessment for banks seeking to access ELA, and testing its ability to accept and value non-standard collateral.
  - Updating the deposit protection regime to ensure full consistency with the resolution regime and underpin current high levels of depositor confidence, through:
    - expanding the Deposit Protection Board (DPB)’s mandate to allow it to contribute to the costs of a resolution;
    - increasing the DPB’s integration into interagency crisis coordination arrangements;
    - expanding deposit preference;
    - reviewing the relatively low target level of the Deposit Protection Scheme (DPS) fund.
- Note on incident reporting: current incident reporting timeframes are varied across the financial sector and could be aligned where appropriate.

*People’s Republic of China—Hong Kong SAR, International Monetary Fund (excerpt).*

### Box 1. Climate Change Risks for the Hong Kong SAR Financial Sector

### Box 1. Climate Change Risks for the Hong Kong SAR Financial Sector

### Overview of climate risk types and horizon
- Hong Kong SAR’s financial sector is exposed to both short-term and long-term climate risks.
- Short-term risks: physical risks from recurring flooding, typhoons and wildfires.
- Long-term risks: transition risks for firms and banks during the shift from a high- to low-carbon economy; some physical risks may also have longer-term impacts.

### Physical risk: current assessment and empirical findings
- For now, physical risks appear generally well managed.
- Regression analysis of sectoral stock price returns on lagged returns and climate events finds the impact of past climate events on GDP is generally limited and short-lived with no significant impact beyond 1 quarter.
- Exception: for insurance companies, the impact appears both significant and large (referenced as Figure 10, panel 1 in main text).
- Over the longer term, physical risk could become more intense and widespread, affecting banks and asset markets as frequency and intensity of climate event risks increase globally and have longer-lasting macro impacts.

### Asset pricing anomaly: temperature risk
- There appears to be a persistent asset pricing anomaly with regard to temperature risk: more exposed stocks carry a too low risk premium.
- Method: rolling regression Fama-MacBeth type analysis of equity prices, sorting Hong Kong SAR stocks on sensitivity to a temperature factor (quarterly data 1990 Q1-2019 Q4; temperature factor computed as the deviation of current from average temperature of the same month in the past 30 years).
- Finding: the top-20 percent firms in terms of sensitivity to the temperature factor appear to underperform other firms by about 1 percentage point each month.

### Transition risk: bank portfolio exposures and sectoral vulnerabilities
- Hong Kong SAR banks may be exposed to climate transition risk stemming from the sectoral composition of their loan and debt securities holdings.
- Mechanism: industries with higher GHG emissions face pressure to reduce CO2-intensity or face higher GHG taxation or activity restrictions; this can lead to lower firm profitability for a prolonged period, higher risk premia for more polluting industries, or higher risk weights on loans or debt holdings—affecting bank performance and resilience.
- Banks with large exposures to energy and transportation—the most polluting in terms of GHG emissions—are especially vulnerable to climate transition risk.

### Banks’ sectoral loan composition and GHG emission concentrations (data and magnitudes)
- Breakdown used: Hong Kong SAR banks’ 2018Q4 loans and advances by economic sector for use in Hong Kong SAR combined with 2017 GHG emissions data from HK government and Exiobase.
- Building and construction (property development and investment):
  - account for 16 percent of the loan portfolio for use in Hong Kong SAR.
  - account for 14 percent of total Mainland-related lending.
  - GHG-emission content is relatively low.
- Domestic and Mainland China exposures to manufacturing, wholesale and retail trade, transportation and agriculture and mining sectors each account for 6 percent or below of the total loan book.
- Electricity and gas account for about 2 percent of the loan book.
- Despite small loan share, the electricity and gas sector’s GHG emission is extremely high relative to other industries, accounting for 65 percent of Hong Kong SAR’s total GHG emissions (40,700 kilotonnes CO2) in 2017.

### Implications and risks to monitor
- Asset-pricing mispricing of temperature risk implies potential for abrupt re-pricing as climate risks materialize or investor awareness changes.
- Sectoral concentration in high-GHG industries (notably electricity and gas, and exposures to energy and transportation) could generate outsized credit losses or higher capital and provisioning needs under transition scenarios.
- Increasing frequency and intensity of climate events could extend physical risk impacts beyond historically observed short-lived effects, raising macro-financial vulnerabilities for banks, insurers, and asset markets.

*International Monetary Fund—Box 1. Climate Change Risks for the Hong Kong SAR Financial Sector*

### Appendix I. Status of Key Recommendations of 2014 FSAP

### Appendix I. Status of Key Recommendations of 2014 FSAP

### Banking Sector
- Recommendation: Eliminate or specify the circumstances triggering the exercise of the legal authority of the Chief Executive of Hong Kong SAR to give directions to the Monetary Authority (MA), and provide for the public disclosure of the reasons for the dismissal of the MA in the Banking Ordinance (BO).
  - Time: MT
  - Status: Not implemented

### Insurance Sector
- Recommendation: Establish the proposed Independent Insurance Authority (IIA).
  - Time: MT
  - Status: Implemented
- Recommendation: Update the Insurance Companies Ordinance (ICO) to better reflect current international best practices, including by: (i) extending the fit and proper regime to cover Senior Management and Key Persons in Control Function; (ii) establishing a clear definition of control and pre-determined control levels; (iii) updating risk management requirements; (iv) granting authority to remove or disqualify persons on fit and proper grounds; and (v) requiring insurers to implement contingency plans.
  - Time: C
  - Status: Implemented
- Recommendation: Amend the ICO to establish a regulatory regime for insurance groups.
  - Time: ST
  - Status: Implemented
- Recommendation: Amend the ICO to implement a risk-based capital regime.
  - Time: ST
  - Status: Underway
- Recommendation: Strengthen conduct of business requirements and direct supervision of insurance intermediaries.
  - Time: ST
  - Status: Implemented

### Securities Market
- Recommendation: Strengthen secondary markets regulation by (i) expanding oversight regime of the HKEX; and (ii) further developing clear and transparent requirements for the recognition of exchanges and the authorization of automated trading services.
  - Time: ST
  - Status: Implemented
- Recommendation: Strengthen auditors' oversight by (i) enhancing the independence of the auditor oversight body; (ii) strengthening the enforcement framework; and (iii) expanding the scope of oversight to all auditors of companies listed in Hong Kong SAR.
  - Time: ST
  - Status: Implemented
- Recommendation: Strengthen enforcement by (i) providing the scope for the SFC to take both punitive and remedial actions in cases where breaches of the Code of Conduct do not contravene the law; and (ii) improving the existing coordination arrangements for criminal enforcement.
  - Time: ST
  - Status: Implemented

### Financial Market Infrastructures
- Recommendation: Develop a clear timetable for each FMI for compliance with the PFMIs.
  - Time: ST
  - Status: Implemented
- Recommendation: Develop a recovery and resolution plan for each FMI (in line with the resolution regime).
  - Time: MT
  - Status: Implemented

### Crisis Management and Resolution
- Recommendation: Continue efforts to develop a comprehensive resolution regime, in line with emerging international good practices.
  - Time: ST
  - Status: Largely complete
- Recommendation: Review the modalities (target size; normal premium level; surcharge premiums for replenishment) for ensuring the deposit protection fund has the appropriate resources to meet its objectives without undue reliance on the Exchange Fund.
  - Time: MT
  - Status: Partially complete

*Note: Short-term indicates within 18 months; medium-term indicates within 18 months to 3 years.*

*Source: Appendix I and Appendix II content from the provided IMF document.*

### Appendix III. Risk Assessment Matrix

### Appendix III. Risk Assessment Matrix

### Global risks: sources, transmission channels, and staff assessment
- Unexpected shift in the Covid-19 pandemic
  - Transmission channels: Prolonged pandemic (e.g., new virus strains, short effectiveness of vaccines, or widespread unwillingness to vaccinate) requires costly containment and prompts persistent behavioral changes rendering many activities unviable.
  - Likelihood: Medium
  - Impact: Medium
- Accelerating de-globalization
  - Transmission channels: Geopolitical competition leads to further fragmentation despite multilateral efforts; reshoring and less trade reduce potential growth.
  - Likelihood: Medium
  - Impact: High
- A sharp rise in global risk premia exposing financial and fiscal vulnerabilities
  - Transmission channels: Reassessment of market fundamentals (e.g., adverse Covid-19 developments) triggers a widespread risk-off event; risk asset prices fall sharply, volatility spikes; major non-bank financial institutions incur significant losses; higher risk premia create financing difficulties for leveraged firms and households; bankruptcies erode banks’ capital buffers.
  - Likelihood: Medium
  - Impact: High

### Domestic risks affecting Hong Kong SAR: sources, transmission channels, and staff assessment
- A further slowdown in Mainland China
  - Transmission channels: Reduced trade flows leading to a sharp decline in Hong Kong SAR economic activity; lower trade volumes reduce corporate profits and investment, raise unemployment, and weaken consumption; trade, logistics, tourism, and retail sectors most affected; banks likely to face higher losses on Mainland China-related and other corporate borrowers and on broader credit portfolio.
  - Likelihood: Medium
  - Impact: High
- A sharp housing market correction and decline in demand
  - Transmission channels: Sharp decline in house prices lowers confidence, weakens housing demand, lowers residential investment, and constrains new bank lending because many loans are secured by property, leading to a larger downturn.
  - Likelihood: Medium
  - Impact: High

### Notes on the Risk Assessment Matrix (RAM)
- The table lists shocks to be used for financial institutions' resilience analysis.
- The RAM shows events that could materially alter the baseline path (the scenario most likely to materialize in IMF staff’s view).
- The RAM reflects staff views on sources of risks and overall level of concern as of discussions with the authorities.
- Non-mutually exclusive risks may interact and materialize jointly, amplifying each other’s effects.

### Authorities’ statement: key points of Mr. Jin and Mr. Law (May 21, 2021)
- Appreciation and agreement
  - Authorities thank staff for the Financial System Stability Assessment (FSSA) report, appreciate constructive discussions, and broadly agree with staff’s appraisal.
  - Financial sector demonstrated remarkable resilience and stability during the real-life stress test.
- Latest economic developments and outlook
  - Hong Kong SAR entered the COVID-19 crisis with a healthy economy, solid fiscal position, and sound financial system.
  - Containment strategy: border control, extensive testing, contact tracing, prompt isolation, transparent disclosure, and public hygiene practices.
  - Infection metrics: Infection cases are now down 99 percent from peak; in the past 14 days, a total of seven local cases reported, of which only one has an unknown infection source.
  - Vaccination: inoculation rate remains relatively slow; threat of new variants under close monitoring; top priority is to contain the pandemic and raise vaccination rates.
  - Fiscal relief: Anti-epidemic Fund (AEF) and other relief measures amount to over HK$300 billion (around US$39 billion), equivalent to about 10-11 percent of GDP.
  - Additional countercyclical fiscal measures in 2021-22 Budget include consumption vouchers and loans for unemployed individuals and small and medium-sized enterprises.
  - Growth: After contractions of 1.2 percent and 6.1 percent in 2019 and 2020 respectively, real GDP expanded by 7.9 percent year-on-year in Q1 2021. Authorities project real GDP growth in the range of 3.5-5.5 percent for 2021.
  - External outlook: Mainland China’s strengthening anticipated to support exports; recovery in other major economies hinges on mass vaccination success.

### Hong Kong SAR’s role as an international financial center
- Capital markets and connectivity
  - Hong Kong SAR provides a high-quality financial platform for global investors, financiers, asset managers, funds, and financial institutions.
  - In 2020 Hong Kong SAR captured 34 percent (or US$196 billion) of Asian international bonds.
  - Stock Connect and North-bound Bond Connect enable international investors to trade Mainland securities through Hong Kong SAR; around 70 percent of all China A-shares held by international investors are booked or traded through Hong Kong SAR.
  - Bond Connect average daily turnover: tripled in 2019 and almost doubled again in 2020.
- Asset management and product development
  - Number of asset managers increased by 3.9 percent year-on-year to 1,878 as at end-2020.
  - Hong Kong SAR is the largest international asset management hub in Asia, largest international private wealth management and hedge fund center in Asia, and second largest private equity center in Asia.
  - Preparations for cross-boundary Wealth Management Connect and South-bound Bond Connect are underway, expected to be launched later in the year.
- Role in regional green finance
  - Authorities plan to double the size of the Government Green Bond Programme to HK$200 billion (around US$25.6 billion) to allow further green bond issuance within the next five years, supporting green projects and in line with target to achieve carbon neutrality before 2050.
  - HKMA partnership with IFC in the Alliance for Green Commercial Banks; HKMA will serve as hub for green finance among commercial banks in Asia.

### Risk assessment, stress testing, and financial buffers
- Reserves and exchange rate regime
  - Foreign exchange reserves and fiscal reserves stood at 140 percent and 32 percent as of end-2020.
  - Staff confirmed resilience of the Linked Exchange Rate System (LERS); HKD exchange rate remained in the strong half of the convertibility zone since 2020.
- Banking system health
  - Total capital adequacy ratio of local banks: 20.7 percent at end-2020 (international minimum requirement is 8 percent).
  - Liquidity coverage ratio: 155.1 percent at end-2020 (statutory minimum requirement is 100 percent).
  - Stress tests indicate banking system is broadly resilient under adverse scenarios to severe macro-financial and liquidity shocks.
  - Non-performing loan ratio of Mainland China-related loans: around 0.96 percent at end-2020; banking system non-performing loan ratio: 0.9 percent.
- Property market and household balance sheets
  - Authorities view three-pronged approach (macroprudential measures, demand-side management, and increase in housing supply) as appropriate.
  - Household debt: increased to 90.2 percent of GDP in Q4 2020 from 80.4 percent a year earlier.
  - Household debt growth: moderated to 5.5 percent in 2020 (compared with 12.8 percent in 2019).
  - Residential mortgage loans represent 68 percent of household debt.
  - Since 2009, residential mortgage loans grown by 1.6 times; property prices increased by 2.5 times.
  - Safe assets-to-liabilities ratio: 2.88 times.
  - Household net worth-to-liabilities ratio: 11.2 times.
- Corporate leverage
  - Weighted average debt-to-equity ratio rose from 45.3 percent in 2008 to 61.6 percent in 2019.
  - Nonfinancial corporate (NFC) debt increased from 202 percent of GDP in 2014 to 257 percent in Q3 2020.
  - Authorities note caution when interpreting NFC debt-to-GDP ratio due to multinational and non-local corporates borrowing in Hong Kong SAR for overseas operations not fully reflected in local GDP.

### Macroprudential, microprudential, and supervisory framework
- Macroprudential policy framework and oversight
  - Council of Financial Regulators (CFR) and Financial Stability Committee (FSC) chaired by the Financial Secretary provide high-level cross-sectoral setup.
  - Bilateral memoranda of understanding enhance collaboration and information-sharing among financial regulators.
  - Authorities will explore further enhancements to monitoring systemic risks and regulatory regime as necessary.
  - Eight rounds of countercyclical macroprudential measures on property mortgage loans since 2009 have enhanced banks’ resilience.
  - HKMA adjusted loan-to-value caps for mortgage loans on non-residential properties upward by 10 percentage points in August 2020; authorities do not intend to relax demand-side measures for private residential property at this time.
- Microprudential oversight and market infrastructure
  - Regulatory and supervisory regimes generally in line with international standards; financial institutions are well capitalized with good risk management frameworks.
  - Basel III framework and domestic and cross-border cooperation arrangements are firmly in place for banking sector.
  - HKMA enhances data collection via the Granular Data Reporting initiative to collect transactional-level data.
  - HKFE Clearing Corporation Limited (HKCC) observes the Principles for Financial Market Infrastructures (PFMI) and has a sound legal basis; staff recommended decentralization of key functions while authorities note past decentralization proved deficient locally.
  - Insurance Authority (IA) established in 2015 has strengthened insurance regulation and resolution powers.
  - Securities and Futures Commission (SFC) consulting on an OTC securities transactions reporting regime to enhance surveillance of OTC trades.
- Anti–money laundering / combatting terrorist financing (ML/TF)
  - Hong Kong SAR has a robust regime; FATF mutual evaluation commends strong legal foundation and effective system, particularly in risk identification, law enforcement, asset recovery, counterterrorist financing, and international cooperation.
  - Authorities will continue to implement FATF recommendations.

### Crisis management, safety nets, fintech, and innovation
- Crisis management and financial safety net
  - Framework strengthened after 2014 FSAP and now broadly adequate.
  - Financial Institutions (Resolution) Ordinance (FIRO) effective 2017 establishes cross-sectoral resolution regime compliant with international resolution standards.
  - Staff recommended extending mandate of the Hong Kong Deposit Protection Board to contribute to resolution costs; authorities note Deposit Protection Scheme’s primary focus is depositor protection and will consider scope review.
- Fintech and financial innovation
  - Authorities pursued initiatives including seven “Smart Banking” initiatives announced in September 2017 (open API for banks, faster payment system, common QR code standard for retail payments, trade finance initiatives, virtual banking); most implemented.
  - Close contact with industry and other jurisdictions; work with BIS Innovation Hub Hong Kong Centre on central bank digital currency cross-border payments research.
  - Authorities adopt risk-based, technology-neutral supervision with sandboxes; aim to balance innovation facilitation with safeguarding customer interests and monitoring risks (cybersecurity, liquidity, concentration).
- Climate change and green finance
  - Authorities to take forward strategic plan announced in December 2020 to develop green and sustainable finance and leverage Hong Kong SAR’s international financial center role.
  - Plan to issue government green bonds regularly and double Government Green Bond Programme to HK$200 billion (around US$25.6 billion) over next five years.
  - HKMA partnership with IFC under the Alliance for Green Commercial Banks to support banks’ transition to green banking; HKMA to serve as regional hub.

*Statement by Mr. Jin, Executive Director, and Mr. Law on the People's Republic of China - Hong Kong Special Administrative Region; May 21, 2021; Appendix III. Risk Assessment Matrix.*

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_Source: https://www.imf.org/-/media/files/publications/cr/2021/english/1hkgea2021001.pdf_