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### FINANCIAL SYSTEM STRUCTURE
- HKSAR’s financial sector ranks number one in the World Economic Forum Financial Development Index.
- Banking system:
  - Assets of US$2 trillion, equivalent to 705 percent of GDP.
  - 201 institutions: 156 licensed banks—135 foreign branches, 14 subsidiaries of foreign banks, remainder domestic banks.
  - Hong Kong operations of nine of the 29 global systemically important banks (G-SIBs) with banking activities in HKSAR warrant HKMA participation in their Crisis Management Group (CMG).
  - Assets of the four largest banks account for almost half the consolidated assets of the banking system.
  - Foreign branches account for about 35 percent of total assets of the banking system and about 27 percent of domestic lending.
- Securities markets:
  - As of June 2013, total market capitalization of the stock exchange was US$2.7 trillion, or 1,000 percent of GDP.
  - The stock market lists about 1,567 companies: 743 from the Mainland (representing 56 percent of the total capitalization), 722 from HKSAR, and the rest mainly from Asia.
  - Total market value of outstanding debt issues was US$154 billion across 355 issues.
- Insurance sector:
  - In 2012, HKSAR ranked 4th for insurance penetration (12.9 percent of GDP) and 7th for insurance density (US$4,719 per capita).
  - 155 licensed insurers; foreign-owned insurers hold about 72 percent of total assets.
  - Long-term insurance industry concentration: as of end-2012, assets of the top three long-term insurers accounted for 46 percent of total assets.

### RECENT ECONOMIC DEVELOPMENTS AND BUFFERS
- Real GDP growth in 2013: 2.9 percent.
- Inflation: around 4 percent.
- Budget surplus: surpassed 3 percent of GDP.
- Exchange Fund (as of December 2013):
  - US$391 billion of assets, of which US$174 billion back the monetary base.
  - Remainder represents accumulated fiscal surpluses available as flexible buffers.
- Linked Exchange Rate System (LERS) underpinned by the Exchange Fund; primary purpose to maintain currency stability and legal mandate to provide liquidity and capital to the banking system.

### FINANCIAL SECTOR TRENDS AND SOUNDNESS
- Banking sector indicators:
  - Capital adequacy ratios (CARs): around 16 percent.
  - Tier 1 capital ratio: over 13 percent.
  - Liquidity ratio: 39 percent (statutory minimum is 25 percent).
  - Net interest income has steadily improved since 2010.
- Insurance industry:
  - Premiums grew by a cumulative 54 percent between 2009 and 2012.
  - Solvency (as at end-2012):
    - Long-term insurers: available capital resources of 1.9 times the prescribed capital requirement (of 1.5 times the minimum solvency requirement).
    - General insurers: 5.6 times the minimum.
    - Reinsurers: 6.4 times the minimum.
  - Authorities monitor insurers with solvency less than 200 percent of the minimum solvency requirement.
  - Current solvency regime: rules-based and largely modeled on the European Union’s Solvency I.
- Credit developments:
  - Credit grew by 16 percent in 2013.
  - Credit in Hong Kong dollars grown at around 8 percent year-on-year.
  - Loan-to-deposit (LTD) ratio reached 72 percent in June 2013.
  - RMB LTD ratio remained below 16 percent.
  - Customer deposits around 55 percent of total liabilities in December 2012; interbank funding around 25 percent; debt instruments over 5 percent.
  - Corporate lending reached about 151 percent of GDP in December 2013.
  - Household debt reached 62 percent; mortgages account for about 45 percent of GDP.
  - Best lending rate-based mortgage rates currently around 2.3 percent.
  - According to the 2011 census, about 10 percent of households with mortgages pay more than 40 percent of their income to service mortgages compared to about 25 percent in 2001.

### KEY RISKS
- Major risk drivers:
  - Anticipated exit from unconventional monetary policy in the United States could increase capital market volatility and reduce system-wide liquidity.
  - Property prices at historical highs; a correction poses risks for borrowers and banks.
  - Increasing economic and financial integration with Mainland China creates expansion opportunities and significant spillover risks in case of a significant financial disruption or economic slowdown.
- Operating environment challenges:
  - Disorderly U.S. monetary exit could cause disruptive capital outflows and liquidity pressures, tightening conditions for adjustable-rate mortgages.
  - Integration with Mainland, combined with Mainland capital controls, may expose HKSAR to unrecorded cross-border financial activities and tighten RMB offshore liquidity in a Mainland slowdown.
  - Deterioration in the Euro area could adversely affect HKSAR.

### RESILIENCE TO RISKS — STRESS TESTS (SUMMARY)
- Methodology and coverage:
  - Three-pronged solvency approach covering about 50 to 60 percent of total assets of the domestic banking sector (and 99 percent of all locally incorporated banks): Bottom-up (BU), Top-down (IMF TD and HKMA TD), and market-based SCCA.
  - BU and IMF TD assume static balance sheets with credit growth in line with nominal GDP growth; HKMA TD and SCCA assume absence of credit growth.
  - Macro scenarios:
    - Baseline: based on WEO April 2013 and Article IV staff report for P.R. China June 2013.
    - Slow growth (SG): cumulative loss of GDP of roughly 9 percent over five years; property prices decline by 30 percent; equity prices decline by 50 percent.
    - Severe adverse (SA): cumulative loss of just over 12 percent over five years; property prices decline by 40 percent; equity prices decline by 65 percent; includes more significant Mainland slowdown.
  - Transmission channels: impairment charges and mark-to-market changes; changes in pre-impairment income including funding costs; changes in RWAs; external developments (sovereign risk, exchange rate).
- Key solvency findings:
  - Banking sector remains sufficiently capitalized under current solvency regime; no aggregate capital shortfall across approaches, including SCCA.
  - Capital adequacy measures materially affected by adverse scenarios, with high sensitivity to impairment losses and valuation haircuts.
  - A few smaller banks show slight vulnerability: in two of three TD approaches, marginal capital shortfall of less than 0.2 percent of system-wide Tier 1 capital relative to Basel III requirements for a small number of local banks.
  - SCCA suggests a more significant decline in market-implied capitalization for some banks.
  - Recommendation: continued vigilance and case for additional capital buffers for vulnerable smaller banks over the medium term.
- Liquidity findings:
  - Overall low liquidity risks; banks exceed minimum liquidity ratios, often by large margins.
  - Local banks most vulnerable to shrinking deposit base; foreign branches more dependent on wholesale funding and related-party flows.
  - Banks able to support week-long net cash outflows on a solo basis and no shortage when extending horizon to one month.
  - Basel III measures (LCR and NSFR) examined on a limited sample: average LCR and NSFR remain above 100 percent for end-June 2013 positions; some combined-basis LCR shortfalls due to holdings not qualifying as HQLA.
  - Most sample banks report NSFR values of 100 percent or higher; many report LCR above 60 percent (initial Basel III transition minimum).
  - Policy measures: matched term funding requirement introduced second half 2011; new stable funding requirement to be introduced in January 2014.

### RESILIENCE TO RISKS — SPILLOVER ANALYSIS
- Network analysis (31 banking systems using BIS cross-border interbank data) simulated two tail events:
  - Credit shock: default of a foreign banking system’s interbank obligations with LGD of 80 percent.
  - Funding shock: distress leading to 35 percent of lost funding irreplaceable and fire-sale losses of 80 percent of value.
- Findings:
  - Extreme simulated losses on Mainland interbank exposures would entirely wipe out capital in Hong Kong’s banking system—reflecting rapid expansion in exposures.
  - Second-tier inward risks: Singapore, Japan, the United Kingdom, Korea and the United States.
  - Funding vulnerabilities smaller than credit shock; maximum capital loss less than 18 percent under illustrative scenario.
  - Outward spillovers: Macao SAR most exposed to shocks originating in HKSAR.
- Implication: foreign branches act as group liquidity hubs and are sensitive to cross-border credit and funding shocks; continued monitoring and cross-border cooperation needed.

### FINANCIAL SYSTEM OVERSIGHT — MACROPRUDENTIAL
- Structures:
  - HKMA Macro-Surveillance Committee identifies bank-intrinsic and system-wide risks.
  - Financial Stability Committee integrates views from HKMA, SFC, and IA.
- Macroprudential tools and outcomes:
  - Six rounds of mortgage macroprudential measures since October 2009: LTV and DSR limits; borrower stress-testing requirements.
  - Average LTV at origination reduced from 64 percent in 2009 to 55 percent in H1 2013.
  - Complementary fiscal measures: new stamp duties and doubling of regular stamp duty.
- Policy for relaxation:
  - Priority on safeguarding financial stability; relaxation conditional on clear evidence of substantial downward correction of property prices and moderation of household debt servicing pressure.
- Monitoring non-bank Mainland exposures:
  - Enhanced reporting on lending to non-bank corporates in the Mainland; recommendation to maintain surveillance and supervision priority.

### FINANCIAL SYSTEM OVERSIGHT — MICROPRUDENTIAL (BANKS, INSURANCE, SECURITIES)
- Banking supervision:
  - High level of compliance with Basel Core Principles (BCPs, 2012 revised methodology).
  - Strong corporate governance practices and fit-and-proper oversight.
  - HKMA has de facto operational independence; de jure limits: Chief Executive reserve power under the Banking Ordinance (BO) to give directions to the MA and no statutory provision specifying circumstances for removal/public disclosure of reasons for dismissal of the MA.
  - Recommendations: specify circumstances triggering Chief Executive’s authority to direct the MA and require public disclosure of dismissal reasons.
  - Related-party rules to be expanded to cover other senior management; amend legislation to give HKMA auditor access and removal powers.
  - AML/CTF: AMLO strengthened framework; FATF assessment tentatively scheduled for 2017.
- Insurance supervision:
  - IA exhibits high observance of Insurance Core Principles (ICPs); plans to establish Independent Insurance Authority (IIA) scheduled for 2015.
  - Key ICO updates recommended:
    - Extend fit and proper regime to Senior Management and Key Persons in Control Function.
    - Establish clear definition of control and pre-determined control levels.
    - Update risk management requirements.
    - Grant authority to remove or disqualify persons on fit and proper grounds.
    - Require insurers to implement contingency plans.
  - Group supervision and capital regime:
    - Move towards a risk-based capital (RBC) regime; establish clear valuation standards and risk-sensitive capital requirements.
    - Stop-gap measures: solvency margin requirements for all long-term business classes; supervisory guidance on policyholders’ reasonable expectations; enhance dynamic solvency tests.
  - Further IIA powers recommended: delegated rule-making, public disclosure of removal reasons for agency head, authority over insurer public disclosures, and clarify Chief Executive’s legal authority to direct the IA.
- Securities market supervision:
  - Sound IOSCO implementation; SFC and HKMA are sophisticated regulators.
  - Areas to strengthen:
    - Regulation and supervision of HKEx: implement stronger oversight, review HKEx governance and risk management committee composition.
    - Develop comprehensive regulatory framework for all trading platforms and transparent requirements for exchange recognition and automated trading service authorization.
    - Auditors oversight: enhance independence of the auditor oversight body; strengthen enforcement framework; expand scope to all auditors of companies listed in Hong Kong.
    - Enforcement: provide SFC scope for both punitive and remedial actions where Code of Conduct breaches do not contravene law; improve coordination for criminal enforcement.
  - Recommendation: strengthen de jure independence of regulatory authorities.

### FINANCIAL MARKET INFRASTRUCTURES (FMIs)
- FMIs are sophisticated, multi-currency, and systemic with effective oversight.
- Authorities committed to compliance with Principles for Financial Market Infrastructures (PFMIs).
- Recommendations:
  - Develop a clear timetable for each FMI for compliance with the PFMIs; HKMA deadline for FMIs under its purview: end-December 2015.
  - Prepare recovery and resolution plans for each FMI in line with the resolution regime.

### CRISIS MANAGEMENT AND BANK RESOLUTION
- Current powers:
  - MA powers under Section 52 of the BO: require AIs to take actions; direct an AI to seek advice from an “Advisor”; appoint a temporary “Manager”.
  - Outside Section 52: MA can withdraw consent from chief executives/executive officers (under conditions), suspend/impose conditions on/revoke authorizations for locally incorporated AIs.
  - MA has means and procedures to provide liquidity or capital support; Exchange Fund resources support systemic assistance; LOLR policy limits ELA to solvent banks where failure to provide liquidity may threaten system stability.
- Gaps and recommendations:
  - Many powers in FSB’s Key Attributes are absent or limited (e.g., powers to override certain rights and impose losses on shareholders and creditors).
  - Recommendation: continue legislative process to establish a comprehensive resolution regime aligned with international good practices and ensure operational independence of resolution authority.
  - HKMA developing recovery and resolution planning requirements: first group of AIs to submit recovery plans in Q3 2014 with resolution plans to follow.
  - Recommendation: review deposit protection scheme modalities (target size; normal premium level; surcharge premiums for replenishment) to reduce reliance on Exchange Fund and ensure appropriate private sector burden-sharing.
  - Suggested DPB changes: review surcharge rules; consider covering deposits gross of depositors’ liabilities for faster pay-outs; formalize arrangement with HKMA for early warning indicators.

### DEPOSIT PROTECTION SCHEME
- Target fund size: 0.0490 percent of the total amount of covered deposits, depending on the risk profile of each bank as measured by the CAMEL framework of the HKMA.
- Comparable reference: Singapore’s target size of 0.30 percent of covered deposits.
- Scheme is pre-funded through risk-based levies; yearly premium varies between 0.0175 percent and 0.0490 percent of covered deposits depending on bank risk profile (premium range implied by text).

### MACROPRUDENTIAL AND PROPERTY MEASURES — TIMELINE (selected entries)
- October 2009: LTV capped at 60 percent for residential properties valued at HK$20 million or more; 70 percent LTV continues below HK$20 million but maximum loan HK$12 million.
- August 2010: LTV capped at 60 percent for properties ≥HK$12 million and non-owner occupied; DSR standardized to 50 percent; stressed DSR limit 60 percent; stress-test mortgage applicants with +2 percentage points; cap maximum loan amounts.
- November 2010: LTV lowered to 50 percent for properties ≥HK$12 million; special stamp duty: 15 percent (<=6 months), 10 percent (6–12 months), 5 percent (12–24 months).
- June 2011: LTV 50 percent for residential ≥HK$10 million; various LTV reductions and caps; applicable LTV lowered by at least 10 percentage points if principal income not derived from Hong Kong.
- September 2012: For applicants already with outstanding mortgages: maximum LTV 30 percent (from 40 percent) for net-worth assessed loans; DSR lowered to 40 percent (from 50 percent); maximum stressed DSR lowered to 50 percent (from 60 percent); maximum loan tenor limited to 30 years.
- October 2012: Special Stamp Duty raised to 20/15/10 percent (various holding periods); Buyer’s Stamp Duty of 15 percent introduced for buyers except permanent residents.
- February 2013: LTV lowered by 10 percentage points for commercial and industrial properties; car park mortgage LTV set at 40 percent and tenor 15 years; stressed mortgage assumption increased to 300 basis points; risk weight floor of 15 percent on new residential mortgages under IRB; ad valorem stamp duty rates doubled to a maximum of 8.5 percent (except for certain permanent residents).

### KEY RECOMMENDATIONS (PRIORITY HIGHLIGHTS)
- Banking sector:
  - Eliminate or specify circumstances triggering the Chief Executive’s authority to give directions to the MA, and provide for public disclosure of reasons for dismissal of the MA in the BO. Priority: medium-term.
- Insurance sector (short-term unless stated):
  - Establish the proposed Independent Insurance Authority (IIA). Priority: short-term.
  - Update ICO to reflect international best practices (extend fit and proper regime; define control; update risk management; authority to remove/disqualify; contingency plans). Priority: short-term.
  - Amend ICO to establish regulatory regime for insurance groups. Priority: short-term.
  - Amend ICO to implement a risk-based capital regime. Priority: short-term.
  - Strengthen conduct of business requirements and direct supervision of insurance intermediaries. Priority: short-term.
- Securities market (short-term):
  - Strengthen secondary markets regulation: expand oversight of HKEx; develop requirements for recognition of exchanges and authorization of automated trading services.
  - Strengthen auditors' oversight: enhance independence of auditor oversight body; strengthen enforcement; expand oversight to all auditors of listed companies.
  - Strengthen enforcement: provide SFC scope for punitive and remedial actions for Code of Conduct breaches not contravening law; improve coordination for criminal enforcement.
- FMIs:
  - Develop clear timetable for each FMI for compliance with PFMIs. Priority: short-term.
  - Develop recovery and resolution plan for each FMI (in line with resolution regime). Priority: medium-term.
- Crisis management and resolution:
  - Continue efforts to develop a comprehensive resolution regime in line with emerging international good practices. Priority: short-term.
  - Review deposit protection fund modalities (target size; normal premium level; surcharge premiums). Priority: medium-term.
- Note: Short-term indicates within 18 months; medium-term indicates within 18 months to 3 years.

### SELECTED BANKING SECTOR INDICATORS (2007–2013/H1)
- Return on average assets: 1.4, 0.6, 0.8, 0.9, 0.8, 0.9, 1.2
- Return on average equity: 23.2, 13.4, 15.4, 15.2, 15.8, 15.3, 15.1
- Interest margin to gross income: 42.8, 57.5, 47.7, 44.0, 45.2, 47.9, 44.2
- Non-performing loans (NPL) as percent of gross loans: 0.7, 1.2, 1.6, 0.8, 0.7, 0.6, 0.5
- Regulatory capital to risk-weighted assets: 13.4, 14.7, 16.8, 15.8, 15.8, 15.7, 15.9
- Regulatory Tier 1 capital to risk-weighted assets: 10.4, 11.0, 12.9, 12.2, 12.4, 13.3, 13.1
- Capital to assets: 8.5, 7.5, 8.8, 8.6, 8.1, 8.7, 8.8
- Total assets (in percent of GDP): 627.0, 629.8, 641.0, 691.7, 709.8, 727.7, 704.8
- Residential real estate loans (share of total loans): 19.0, 18.0, 19.7, 17.6, 15.8, 15.7, 14.8
- Commercial real estate loans (share of total loans): 7.6, 8.0, 8.1, 7.0, 6.8, 6.6, 6.4
- FX loans (share of total loans): 26.2, 28.3, 27.0, 33.2, 37.8, 40.1, 42.8
- Customer deposits (share of funding): 56.7, 56.3, 60.0, 55.8, 55.2, 55.8, 55.5

### MACROECONOMIC PROJECTIONS (SELECTED)
- Real GDP (2013 est.): 2.96
- Baseline real GDP forecasts (2014–2018): 4.39, 4.37, 4.46, 4.46, 4.51
- Slow Growth (SG) scenario real GDP forecasts (2014–2018): 1.78, 2.66, 2.70, 2.99, 2.95
- Severe Adverse (SA) scenario real GDP forecasts (2014–2018): 1.32, 0.63, 2.38, 2.91, 2.84
- Consumption prices (average CPI) baseline forecasts (2014–2018): 3.67, 3.57, 3.54, 3.53, 3.53

### STRESS TEST FRAMEWORK (APPENDIX II — STeM HIGHLIGHTS)
- Solvency tests: BU (banks), TD (HKMA and FSAP), MB (SCCA).
- Liquidity tests: Basel III LCR/NSFR, HKMA 7-day/ELST, IMF implied cash flow tests, WH (Wong-Hui, 2009).
- Coverage examples:
  - BU: about 50 percent of banking sector assets (consolidated).
  - TD (FSAP team): 16 banks; 63 percent of assets.
  - TD (HKMA): 19 banks; 58 percent of assets (combined).
  - Liquidity tests sample: 19 local banks and 8 foreign branches representing 71 percent of banking sector assets (solo basis).
- Risk horizons:
  - BU/TD/MB: 5 years; HKMA TD: 2 years; B3: 30-day and 1-year; ELST: 7-day; CF: 5-day and 30-day; WH: 1-year.
- Metrics:
  - Solvency: Basel III CET1, Tier 1, Total Capital, conservation buffer.
  - Liquidity: LCR and NSFR, distribution of ratios, number of failed banks (ratio<100 percent), liquidity shortfall relative to unencumbered assets.

*People’s Republic of China––Hong Kong Special Administrative Region: Executive Summary and selected excerpts (IMF staff and HKMA data and analysis).*

### EXECUTIVE SUMMARY ___________________________________________________________________________  6

### EXECUTIVE SUMMARY

### FINANCIAL SYSTEM STRUCTURE
- HKSAR’s financial sector ranks number one in the World Economic Forum Financial Development Index.
- Banking system:
  - Assets of US$2 trillion, equivalent to 705 percent of GDP.
  - 201 institutions: 156 licensed banks—135 foreign branches, 14 subsidiaries of foreign banks, remainder domestic banks.
  - Hong Kong operations of nine of the 29 global systemically important banks (G-SIBs) with banking activities in HKSAR warrant HKMA participation in their Crisis Management Group (CMG).
  - Assets of the four largest banks account for almost half the consolidated assets of the banking system.
  - Foreign branches account for about 35 percent of total assets of the banking system and about 27 percent of domestic lending.
- Securities markets:
  - As of June 2013, total market capitalization of the stock exchange was US$2.7 trillion, or 1,000 percent of GDP.
  - The stock market lists about 1,567 companies: 743 from the Mainland (representing 56 percent of the total capitalization), 722 from HKSAR, and the rest mainly from Asia.
  - Total market value of outstanding debt issues was US$154 billion across 355 issues.
- Insurance sector:
  - In 2012, HKSAR ranked 4th for insurance penetration (12.9 percent of GDP) and 7th for insurance density (US$4,719 per capita).
  - 155 licensed insurers; foreign-owned insurers hold about 72 percent of total assets.
  - Long-term insurance industry is highly concentrated: as of end-2012, the assets of the top three long-term insurers accounted for 46 percent of the total assets.

### RECENT ECONOMIC DEVELOPMENTS AND BUFFERS
- Real GDP growth in 2013: 2.9 percent.
- Inflation: around 4 percent.
- Budget surplus: surpassed 3 percent of GDP.
- Exchange Fund (as of December 2013):
  - US$391 billion of assets, of which US$174 billion back the monetary base.
  - Remainder represents accumulated fiscal surpluses available as flexible buffers.
- Linked Exchange Rate System (LERS) underpinned by the Exchange Fund; primary purpose to maintain currency stability and legal mandate to provide liquidity and capital to the banking system.

### FINANCIAL SECTOR TRENDS AND SOUNDNESS
- Banking sector soundness indicators:
  - Capital adequacy ratios (CARs): around 16 percent.
  - Tier 1 capital ratio: over 13 percent.
  - Liquidity ratio: 39 percent (statutory minimum is 25 percent).
  - Net interest income has steadily improved since 2010.
- Insurance industry growth:
  - Premiums grew by a cumulative 54 percent between 2009 and 2012.
  - Solvency (as at end-2012):
    - Long-term insurers: available capital resources of 1.9 times the prescribed capital requirement (of 1.5 times the minimum solvency requirement).
    - General insurers: 5.6 times the minimum.
    - Reinsurers: 6.4 times the minimum.
  - Authorities closely monitor insurers with solvency less than 200 percent of the minimum solvency requirement.
  - Current solvency regime: rules-based and largely modeled on the European Union’s Solvency I.

### KEY RISKS
- Major risk drivers:
  - Anticipated exit from unconventional monetary policy in the United States could increase capital market volatility and reduce system-wide liquidity.
  - Property prices at historical highs; a correction poses risks for borrowers and banks.
  - Increasing economic and financial integration with Mainland China creates expansion opportunities and significant spillover risks in case of a significant financial disruption or economic slowdown.

### RESILIENCE TO RISKS
- Stress tests:
  - Indicate banks are well positioned to absorb a significant realization of risks.
  - Banks’ aggregate capitalization would remain well above the Basel III’s minimum capital requirement.
  - Banking sector (including foreign branches) has sufficient liquidity to withstand large deposit and wholesale funding withdrawals.
  - A few smaller banks might be slightly more vulnerable under a severe economic scenario.
  - Foreign branches are relatively more sensitive to withdrawals of wholesale funding, reflecting their business models.
  - Implication: continued vigilance on smaller banks and foreign-branch wholesale funding exposures is required.
- Spillover analysis:
  - Increased integration with Mainland China generates significant spillover risks that merit continued monitoring and cooperation (detailed spillover findings are summarized in the full report).

### FINANCIAL SYSTEM OVERSIGHT
- Overall assessment:
  - Regulation and supervision framework is of a high caliber with a high level of compliance with international standards.
  - Scope remains to strengthen oversight, particularly in the insurance sector.
- Macroprudential oversight:
  - Authorities have actively deployed macroprudential policies to mitigate systemic risks.
  - In response to a doubling of house prices, the HKMA introduced tighter limits on loan-to-value (LTV) and debt-servicing (DSR) ratios.
  - Recommendation: strengthen capacity for systemic risk analysis at the Securities and Futures Commission (SFC) and Insurance Authority (IA) to complement HKMA analysis and capture cross-sectoral interconnections.
- Microprudential oversight:
  - Insurance sector priorities:
    - Establish planned Independent Insurance Authority (IIA).
    - Update the Insurance Companies Ordinance (ICO) to reflect international best practices: extend fit and proper regime to Senior Management and Key Persons in Control Function; establish a clear definition of control and pre-determined control levels; update risk management requirements; grant authority to remove or disqualify persons on fit and proper grounds; require insurers to implement contingency plans.
    - Amend ICO to establish a regulatory regime for insurance groups.
    - Amend ICO to implement a risk-based capital regime.
    - Strengthen conduct of business requirements and direct supervision of insurance intermediaries.
  - Securities market priorities:
    - Strengthen secondary markets regulation by: (i) expanding oversight regime of the HKEx; and (ii) developing clear and transparent requirements for recognition of exchanges and authorization of automated trading services.
    - Strengthen auditors' oversight by: (i) enhancing independence of the auditor oversight body; (ii) strengthening the enforcement framework; and (iii) expanding scope of oversight to all auditors of companies listed in Hong Kong.
    - Strengthen enforcement by: (i) providing scope for the SFC to take both punitive and remedial actions where breaches of the Code of Conduct do not contravene the law; and (ii) improving coordination arrangements for criminal enforcement.
  - Governance:
    - Authorities should consider ways to further strengthen the de jure independence of individual regulatory authorities.
- Financial Market Infrastructures (FMIs):
  - FMIs are highly sophisticated and systemic; supported by effective oversight and supervision.
  - Authorities committed to ensuring each FMI complies with the Principles for Financial Market Infrastructures (PFMIs).
  - Recommendations:
    - Develop a clear timetable for each FMI for compliance with the PFMIs.
    - Develop a recovery and resolution plan for each FMI (in line with the resolution regime).

### CRISIS MANAGEMENT AND BANK RESOLUTION
- Current powers and gaps:
  - Authorities have powers to impose temporary management on a troubled institution.
  - Lacking many powers set out in the Financial Stability Board’s Key Attributes of Effective Resolution Regimes for Financial Institutions, including powers to override certain rights and impose losses on shareholders and creditors (absent or limited).
- Recommendations:
  - Move forward with the planned legislative process to establish a comprehensive resolution regime with a robust legal framework.
  - Develop further recovery and resolution planning framework, especially given the role of G-SIFIs in HKSAR.
  - Consider enhancements to the deposit protection scheme:
    - Review modalities (target size; normal premium level; surcharge premiums for replenishment) to ensure the deposit protection fund has appropriate resources without undue reliance on the Exchange Fund.

### CROSS-BORDER REGULATORY COORDINATION
- Given HKSAR’s significant foreign bank presence and integration with Mainland China:
  - Continued active participation in supervisory colleges and crisis management groups of G-SIFIs (both banks and insurance companies) is essential.
  - Sustained strong cooperation with regulatory counterparts is essential to manage risks associated with increased integration with the Mainland.
  - Continued active participation in international regulatory fora is needed to mitigate potential extra-territoriality effects from global regulatory developments.

### TABLE 1 — KEY RECOMMENDATIONS (PRIORITY)
- Banking sector:
  - Eliminate or specify circumstances triggering the Chief Executive’s authority to give directions to the Monetary Authority (MA), and provide for public disclosure of reasons for dismissal of the MA in the Banking Ordinance (BO). Priority: medium-term.
- Insurance sector (all short-term unless stated):
  - Establish the proposed Independent Insurance Authority (IIA). Priority: short-term.
  - Update the ICO to reflect international best practices (extend fit and proper regime; define control; update risk management; authority to remove/disqualify; contingency plans). Priority: short-term.
  - Amend ICO to establish regulatory regime for insurance groups. Priority: short-term.
  - Amend ICO to implement a risk-based capital regime. Priority: short-term.
  - Strengthen conduct of business requirements and direct supervision of insurance intermediaries. Priority: short-term.
- Securities market (short-term):
  - Strengthen secondary markets regulation: expand oversight of HKEx; develop requirements for recognition of exchanges and authorization of automated trading services.
  - Strengthen auditors' oversight: enhance independence of auditor oversight body; strengthen enforcement framework; expand oversight scope to all auditors of listed companies.
  - Strengthen enforcement: provide SFC scope for punitive and remedial actions for Code of Conduct breaches not contravening law; improve coordination for criminal enforcement.
- Financial market infrastructures:
  - Develop clear timetable for each FMI for compliance with PFMIs. Priority: short-term.
  - Develop a recovery and resolution plan for each FMI (in line with resolution regime). Priority: medium-term.
- Crisis management and resolution:
  - Continue efforts to develop a comprehensive resolution regime in line with emerging international good practices. Priority: short-term.
  - Review modalities for deposit protection fund (target size; normal premium level; surcharge premiums for replenishment). Priority: medium-term.
- Note: Short-term indicates within 18 months; medium-term indicates within 18 months to 3 years.

*People’s Republic of China––Hong Kong Special Administrative Region: Executive Summary (IMF).*

### 7.      Although a fully-fledged risk-based capital regime for insurers is not yet in place, the

### 7.      Although a fully-fledged risk-based capital regime for insurers is not yet in place, the

### Insurers oversight
- Authorities pay close attention to insurers’ risk profiles.
- All insurers are subject to quarterly and ad hoc stress tests, while long-term insurers are subject to annual dynamic solvency testing.
- Analysis indicates:
  - Long-term insurers are vulnerable to a protracted period of low interest rates and volatile financial markets.
  - Key risk facing general insurers is intense competition that could lower their profitability.
- Management action to address identified vulnerabilities is closely monitored until fully implemented.
- Footnote: This implies a backing ratio of 107 percent.

### Credit developments
- Credit growth
  - Credit has grown strongly since 2010, supported by low interest rates.
  - Credit grew by 16 percent in 2013.
  - Credit in foreign currency—mostly for use outside HKSAR—has grown by double digits; a significant portion of lending for use outside HKSAR is to the Mainland corporate sector.
  - Credit in Hong Kong dollars—mostly for use in HKSAR—has grown at a steadier pace of around 8 percent year-on-year.
  - On aggregate banks’ maintain a net long position in foreign currency.
- Loan-to-deposit ratio and RMB
  - Loan to deposit (LTD) ratio reached 72 percent in June 2013.
  - Increase especially pronounced in foreign currencies (excluding the renminbi, RMB).
  - RMB loan portfolio remains small; RMB LTD ratio remained below 16 percent.
- Funding structure
  - Customer deposits around 55 percent of total liabilities in December 2012.
  - Interbank funding comprises around 25 percent of total liabilities.
  - Debt instruments comprise over 5 percent of total liabilities.
  - Foreign branches: interbank funding just over 50 percent of their liabilities (most from abroad); deposits just over 30 percent of liabilities.
  - Time deposits share around its trough of 45 percent (compared to 65 percent at the beginning of 2007).
  - Saving deposits have seen stronger growth; demand deposits remain relatively small.
- Corporate and household lending
  - Corporate sector lending reached about 151 percent of GDP in December 2013.
    - With corporate sector lending defined as loans for use in HKSAR plus trade finance but excluding loans to the personal sector.
  - Comparison: Korea about 110 percent; Singapore about 70 percent.
  - Median leverage ratios for companies do not appear out of line with international peers; profitability and interest coverage ratios remain robust.
  - Construction and real estate lending accounts for 25 percent of loans for use in HKSAR; median leverage of the sector appears particularly high.
  - Credit growth to construction and real estate slowed to about 3 percent yoy in 2012–13.
  - Household debt reached 62 percent (highest levels in many years), but relatively low compared to international peers.
  - About one-third of loans for use in HKSAR are to households; mortgages account for about 45 percent of GDP.
  - Debt service and mortgage stress:
    - Best lending rate-based mortgage rates currently around 2.3 percent.
    - According to the 2011 census, about 10 percent of households with mortgages pay more than 40 percent of their income to service mortgages compared to about 25 percent in 2001.

### Key risks
- Operating environment challenges:
  - Anticipated withdrawal of U.S. monetary stimulus expected to lead to tighter financial conditions in HKSAR, including for adjustable-rate mortgages; a disorderly unwinding could cause disruptive capital outflows and liquidity pressures.
  - Increasing integration with the Mainland (through trade and banks’ exposure to nonbank corporates and HKSAR’s role as the principal offshore RMB center) could pose significant risks; significant Mainland financial disruption and economic slowdown would spill over to HKSAR, tightening RMB liquidity conditions and adversely affecting RMB offshore liquidity.
  - Increasing integration, combined with continuing capital controls in the Mainland, potentially exposes HKSAR to unrecorded cross-border financial activities.
  - A significant downturn in property prices could constrain borrowing via reduced collateral values, prompt banks to tighten lending standards, and hinder growth.
  - HKSAR could be adversely affected by a deterioration of the situation in the Euro area.

### Resilience to risks — A. Stress Tests (overview)
- Stress tests quantify impact of key risks and show a high degree of banking sector resilience.
- All large banks well-capitalized and able to withstand a severe deterioration in economic conditions—drop in economic growth, rise in unemployment, decline of property prices, and increasing funding pressures—without any aggregate capital shortfall over a five-year stress horizon.
- Solvency of a marginal number of smaller institutions appears slightly vulnerable.
- High collateralization of mortgages and declining LTV ratios (reflecting authorities’ active use of macroprudential measures) help absorb impact from severe property price shocks.

### Resilience to risks — Solvency risk (methodology)
- Solvency stress tests based on mid-2013 data assess capacity to absorb downside deviations from baseline macroeconomic scenario.
- Three-pronged approach covering about 50 to 60 percent of total assets of the domestic banking sector (and 99 percent of all locally incorporated banks):
  - Bottom-up (BU) balance sheet stress test conducted by banks with mission and HKMA staff (“BU exercise”).
  - Cross-validation by two top-down (TD) balance sheet stress tests: “IMF TD exercise” and “HKMA TD exercise”.
  - Cross-validation by a top-down, market-based stress test using the Systemic Contingent Claims Approach (“SCCA”).
- Notes on assumptions:
  - BU and IMF TD assume a static balance sheet with constant credit growth in line with nominal GDP growth.
  - HKMA TD and SCCA assume absence of credit growth.
  - No asset disposals/divestments after cut-off date; defaulted loans not replenished.
  - HKMA TD shocks are condensed within two-year stress period; magnitude similar to BU and IMF TD over five years.
- Three macroeconomic scenarios examined:
  - Baseline: macro projections based on the WEO of April 2013 and the Article IV staff report for People’s Republic of China of June 2013.
  - Slow growth (SG): cumulative loss of GDP of roughly 9 percent over five years, underpinned by broad-based slowdown including in the Mainland, triggered by an increase in U.S. interest rates.
  - Severe adverse (SA): contraction further aggravated by intensification of capital outflows, generating cumulative loss of just over 12 percent over five years.
    - Property prices decline by 30 percent (SG) and 40 percent (SA).
    - Equity prices decline by 50 percent (SG) and 65 percent (SA).
  - The severe adverse scenario also includes a more significant slowdown in growth in the Mainland.
  - Alternative GDP path with Asian financial crisis calibration was also assessed; sector remains resilient with no aggregate capital shortfall over stress horizon but marginal deterioration relative to SA scenario.
- Transmission channels examined:
  - (i) Impairment charges (credit losses) and mark-to-market valuation changes of fixed income securities.
  - (ii) Changes in pre-impairment income, including funding costs.
  - (iii) Changes in risk-weighted assets (RWAs).
  - Tests also accounted for external developments (sovereign risk valuation changes and exchange rate fluctuations).
- Findings:
  - Banking sector remains sufficiently capitalized under current solvency regime; results consistent across approaches, aligning with aggregated BU findings.
  - All capital adequacy measures (CAR, Tier 1 capital and common equity Tier 1 capital) are materially affected by adverse scenarios, but there is no aggregate capital shortfall—even under SCCA.
  - Results show high sensitivity to rising impairment losses, valuation haircuts on investment assets, and impact of regulatory changes to capital definition and rising default probabilities on RWAs under stress.
  - Impact of interest rate risk remained limited.
  - A few smaller banks show some vulnerability during final years of SA scenario:
    - In two out of three TD approaches, stresses would translate into a marginal capital shortfall of less than 0.2 percent of system-wide Tier 1 capital relative to the Basel III capital requirements for a small number of local banks.
    - The SCCA approach points to a more significant decline in market-implied capitalization; may reflect temporary increase in equity price volatility (rumors of potential mergers and acquisitions).
    - A case could be made for these banks to build additional capital buffers over the medium term.
  - Footnotes: The stress test undertaken for the FSAP differ from typical supervisory stress tests in that findings typically do not require management action by financial institutions; rather, they inform policy discussions. The impact of regulatory changes on RWAs and capital under stress was relatively small for the BU exercise. None of the tested banks failed in two of the three TD approaches at the same time.

### Resilience to risks — Liquidity risk
- Overall low liquidity risks, with funding structures varying across institutions.
- Stricter liquidity regulations by the HKMA (applying to foreign branches) have improved liquidity risk management.
- Stress test outcomes:
  - Banks exceed—and in most cases by a large margin—minimum liquidity ratios due to high cash balances and large holdings of liquid assets.
  - Varying risk drivers across institution types:
    - Local banks most vulnerable to shrinking deposit base.
    - Foreign branches more dependent on wholesale funding and vulnerable to outflows from related-party lending and contingent claims.
  - All banks able to support a short-lived shock to cash outflows.
  - Liquidity stress tests aimed to capture market liquidity risk (scheduled and unscheduled net cash outflows) and funding liquidity risk (restricted access to funding markets).
  - Results suggest banks have sufficient liquid assets to withstand week-long net cash outflows on a solo basis and no liquidity shortage when extending risk horizon to one month; results cover foreign branches.
- Basel III liquidity measures (LCR and NSFR):
  - Examined on limited sample of larger local banks and foreign branches.
  - Average LCR and NSFR remain above 100 percent threshold on both combined and consolidated basis for end-June 2013 positions; most institutions clear threshold with ease.
  - On combined basis, a few banks show insufficient liquidity buffers to meet net cash outflows over 30-day horizon on the LCR measure.
    - Shortfall largely reflects holdings of securities not qualified as high quality liquid assets (e.g., debt securities issued by financial institutions).
    - Expected that banks will adjust portfolios over time given transition timetable.
    - Most banks report LCR ratios above 60 percent (and some close to 100 percent), the initial minimum LCR requirement in the Basel III transition schedule.
  - Most sample banks report NSFR values of 100 percent or higher.
  - Banks’ foreign currency liquidity position closely matched, but overall maturity mismatches increase significantly beyond short tenors, reflecting high proportion of residential mortgages backed by relatively sticky retail deposits.
- Policy measures and calibration:
  - Apart from Enhanced Liquidity Stress Test, in second half of 2011 HKMA introduced a matched term funding requirement where banks experiencing high credit growth were required to obtain matched term funding to support their lending.
  - A new stable funding requirement would be introduced in January 2014 to further enhance resilience.

### Resilience to risks — B. Spillover Analysis
- Network analysis used to explore cross-border interbank vulnerabilities, principally capturing role of foreign branches operating as group liquidity hubs.
- Analysis details:
  - Simulation of two extreme tail events:
    - Credit shock: default of a foreign banking system’s interbank obligations with loss given default of 80 percent.
    - Funding shock: distress of a foreign banking system leading to a liquidity squeeze (35 percent of lost funding assumed irreplaceable) and associated fire sale losses (loss of 80 percent of value).
  - Results:
    - Extreme tail event of simulated losses on Mainland interbank exposures would entirely wipe out capital in Hong Kong’s banking system.
      - Reflects rapid expansion in banks’ exposure in recent years.
    - Second tier risks: Singapore, Japan, the United Kingdom, Korea and the United States.
    - Funding vulnerabilities smaller than credit shock: maximum capital loss less than 18 percent under illustrative scenario, reflecting banks’ relatively small dependence on offshore funding.
    - Largest funding shock risks from Japan, the United States, and the Mainland.
  - The analysis complements stress tests by providing insight into potential vulnerability of banks, particularly foreign branches, to credit and funding shocks.
- Outward spillovers:
  - Network analysis shows outward spillover effects of a credit or funding shock originating in HKSAR.
  - Impact of a funding shock smaller than that of a credit shock.
  - Macao SAR is most exposed to shocks originating in HKSAR.
- Methodological note:
  - Based on Espinosa and Solé (2010) cross-border financial surveillance network perspective.
  - Analysis captured 31 banking systems using BIS data on cross-border interbank exposures.
  - Given focus on foreign branches, an imputed capital is added by scaling up local banks’ reported capital by foreign branches’ share of total banking system assets.

*PEOPLE’S REPUBLIC OF CHINA––HONG KONG SPECIAL ADMINISTRATIVE REGION INTERNATIONAL MONETARY FUND*

### 27.      HKSAR has in place complementary structures for macroprudential and

### _cr14130 - 27.      HKSAR has in place complementary structures for macroprudential and

### Macroprudential Oversight
- Structures and responsibilities:
  - HKMA Macro-Surveillance Committee identifies bank-intrinsic and system-wide risks.
  - Financial Stability Committee provides broader consideration of key systemic risks, integrating views from the HKMA, SFC, and IA.
- Reporting and triggers:
  - HKMA requires AIs (including foreign branches) to report when they are close to, or have breached, a series of trigger ratios, including liquidity ratios.
  - HKMA imposes an additional capital trigger ratio (on an institution specific basis and currently at least 0.5 percentage points over the total minimum CAR).
- Basel III and legislative timeline:
  - Authorities will introduce a capital surcharge on domestic systemically important banks.
  - Legislative changes to enable these measures, which will also include the counter-cyclical capital and capital conservation buffer, are planned for 2014, in time to meet the Basel III timetable.
- Mortgage-related macroprudential measures and outcomes:
  - HKMA introduced six rounds of macroprudential measures since October 2009 to mitigate risks of mortgage lending.
  - Principal measures: limitations on the maximum LTV and limits on the debt servicing (DSR) ratio; banks required to perform stress tests on borrowers as part of loan approval.
  - Result: average LTV at origination reduced from 64 percent in 2009 to 55 percent in the first half of 2013.
  - Complementary fiscal measures: introduction of various new stamp duties and a doubling of the regular stamp duty helped reduce mortgage lending growth, halt the rapid increase in house prices, and moderate property sales.
- Policy considerations for relaxation:
  - Priority placed on safeguarding financial stability in considering any relaxation of macroprudential policies.
  - Required conditions for relaxation: clear evidence of a substantial downward correction of property prices, and possibly moderation of pressure on household debt servicing capacity, given inevitable normalization of mortgage rates over the medium term.
- Monitoring non-bank corporate exposures:
  - Authorities actively monitoring lending to non-bank corporates in the Mainland.
  - HKMA enhanced reporting requirements on these exposures to determine whether macroprudential policies are needed.
  - Recommendation: continue to make surveillance and supervision of these exposures a key supervisory priority.

### Microprudential Oversight — Banking Sector
- Compliance and assessment:
  - HKSAR has a very high level of compliance with the strengthened Basel Core Principles for Effective Banking Supervision (BCPs).
  - HKMA assessed against the 2012 revised methodology.
  - HKMA practices in corporate governance are particularly strong, including close attention to “fit and proper” standards and Board governance of authorized institutions.
- Adoption of international reforms:
  - HKMA an early adopter of many standards; continues to consult industry and implement standards on capital, liquidity and risk management in a timely manner.
  - Legislative process acknowledged; Hong Kong’s ability to meet international timetable reflects HKMA’s communication with the legislature and coordination with regulatory partners.
- Operational independence:
  - HKMA has clear de facto but not de jure operational independence.
  - Chief Executive of HKSAR has a reserve power in the Banking Ordinance (BO) to give directions to the MA; this power has not been used.
  - No statutory provision specifying circumstances for removal of the MA or public disclosure of reasons for dismissal.
  - Safeguards noted, including potential for judicial review.
  - Recommendation: consider further steps to specify circumstances that trigger the Chief Executive’s legal authority to give directions to the MA and provide for public disclosure of reasons for dismissal of the MA.
- Regulatory gaps and recommendations:
  - Related-party rules: current good practices on lending to parties connected to an AI (Directors, controllers, officials responsible for credit approval) do not apply to other senior management; recommendation to expand definition of related party.
  - External auditors: HKMA lacks explicit power to remove an AI’s auditor or access external auditor’s working papers; HKMA has worked around restrictions with FRC support.
  - Recommendation: amend appropriate legislation to address auditor access and removal powers.
- AML/CTF framework:
  - Introduction of the Anti-Money Laundering and Counter-Terrorist Financing (Financial Institutions) Ordinance (AMLO) and issuance of guidelines strengthened the supervisory framework.
  - HKMA increased specialist resources and awareness of AML/CTF concerns.
  - Effectiveness of measures to be assessed by the Financial Action Task Force, tentatively scheduled for 2017.

### Microprudential Oversight — Insurance Sector
- Institutional structure:
  - IA responsible for regulating and supervising the insurance sector; supported by the Office of the Commissioner of Insurance.
  - Self-regulatory system used to supervise conduct of business (CoB) of intermediaries; three self-regulatory organizations (SROs) supervise intermediaries under non-statutory codes approved by the IA.
  - IA supervises SRO oversight, conducts spot checks and independent inspections for quality assurance.
- Observance and supervisory practices:
  - Regulatory regime exhibits a high level of observance of the Insurance Core Principles (ICPs).
  - IA highly regarded; staff have good industry understanding, facilitated by open communication with directors and management of insurers.
  - Established internal procedures and checklists promote supervisory consistency and effectiveness.
- Legal and regulatory updates needed (ICO):
  - Key areas for updating ICO include:
    - (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;
    - (v) requiring insurers to implement contingency plans.
  - Additional suggestions: review list of entities exempted from authorization and clarify priority of claims of long-term policyholders; update guidance notes and differentiate minimum requirements from supervisory guidance.
- Independent Insurance Authority (IIA) plans:
  - Authorities plan to establish an independent IA (IIA), scheduled to be implemented in 2015.
  - IIA would enhance legal capacity, and financial and operational independence; have explicit powers for inspections, investigation, prosecution, and broader sanction powers.
  - Direct licensing and supervision of intermediaries by IIA would replace current self-regulatory regime.
  - Current IA oversight of SROs provides safety net but involves duplication and SROs are not full-fledged supervisors.
- Further strengthening recommendations for proposed IIA:
  - (i) grant delegated authority to issue enforceable rules via administrative means;
  - (ii) require public disclosure of reasons for removing the head of the agency;
  - (iii) grant clear authority to establish and supervise public disclosures by insurers.
  - Consider eliminating or specifying the legal authority of the Chief Executive to give directions to the IA, and specify circumstances for exemption or variation of ICO provisions for individual insurers.
- Group supervision and capital regime:
  - Timely to formulate and implement clear comprehensive regulatory regime for insurance groups covering scope of group-wide supervision and prudential and market conduct requirements at group level.
  - Recommendations:
    - (i) ensure adequate supervisory resources to effectively supervise insurance groups;
    - (ii) consider legal authority to take measures at the level of the holding company.
  - IA currently assumed role of group-wide supervisor for a Hong Kong-based insurance group and leads a supervisory college monitoring group issues.
  - IA’s move towards a risk-based capital (RBC) regime is welcome; recommendation to establish a structured process for macroprudential surveillance.
  - RBC regime should establish clear and consistent valuation standard and risk sensitive capital requirements.
  - As stop-gap measures:
    - establish solvency margin requirements for all classes of long-term business;
    - provide supervisory guidance on insurers’ obligations to meet policyholders’ reasonable expectations.
  - Pending enterprise risk management requirements, enhance current dynamic solvency tests.

### Microprudential Oversight — Securities Market
- Framework and implementation:
  - HKSAR has developed a sound framework exhibiting a high level of implementation of the IOSCO Principles.
  - SFC and HKMA are sophisticated regulators with sound supervisory practices; Lehman minibond experience led to material improvements in conduct supervision.
- Capacity building:
  - SFC continuing efforts to build capacity to identify and monitor emerging risks amid increased interconnection with the Mainland, active presence by international players, and increased regional competition.
- Three areas needing strengthening:
  - Regulation and supervision of markets:
    - Evolution in HKEx business model makes it critical for the SFC to implement a stronger oversight regime, review governance of the HKEx, and review composition of the HKEx risk management committee to ensure an arm’s length relationship between regulators and HKEx.
    - SFC should develop and make public a comprehensive regulatory framework for all types of trading platforms.
  - Auditors’ oversight:
    - Need robust disclosure practices for issuers from jurisdictions with different legal traditions, governance and accounting frameworks.
    - Current framework does not ensure independence of the Hong Kong Institute of Certified Public Accountants, nor provide it powers to oversee foreign auditors of companies listed in HK, nor establish a strong enforcement framework.
  - Enforcement of securities regulation:
    - SFC cannot easily impose both punitive action and secure compensation for clients (remedial action) when breaches of the Code of Conduct do not contravene the law, creating trade-offs.
    - Coordination between SFC and Director of Public Prosecutions on enforcement could be further strengthened.
    - International cooperation, particularly with the Mainland, is critical and requires further commitment from the international community.

- Legal independence:
  - Recommendation: operational independence enjoyed by regulators should translate into stronger de-jure independence with improvements in legal governance arrangements for both SFC and HKMA.

### Financial Market Infrastructures (FMIs)
- Current status:
  - Oversight and supervision of FMIs appears effective.
  - Authorities fostered development of sophisticated and multi-currency FMIs with extensive domestic and overseas system linkages.
- Compliance with PFMIs:
  - Further steps needed to bring FMIs into compliance with the new Principles for Financial Market Infrastructures (PFMIs).
  - Changes required include addressing gaps and changes in financial risk management at clearing houses.
  - Authorities committed to full compliance and should adhere to the announced timetable.
  - HKMA has set a deadline of end-December 2015 for FMIs under its purview to generally comply with the PFMIs.
- Resolution and recovery planning:
  - Authorities should continue drafting legislation establishing a comprehensive resolution regime that includes FMIs.
  - Recovery and resolution plans for each FMI should be prepared.

### Crisis Management and Bank Resolution
- MA powers and intervention tools:
  - MA has powers to intervene in respect of a problem bank as defined in Section 52 of the BO.
  - MA, in consultation with the FS, can:
    - (i) require an AI to take any action in relation to its affairs, business and property;
    - (ii) direct an AI to seek advice from an “Advisor” appointed by the MA;
    - (iii) appoint a temporary “Manager” to manage the affairs, business and property of the AI, specified in a direction by the MA.
  - MA can use these powers when an AI is carrying on business detrimental to depositors and creditors, or when insolvent or likely to be unable to meet obligations.
  - Outside Section 52, under certain conditions, MA can withdraw consent from (and thereby effect removal of) chief executive and executive officers of an AI, and, for locally incorporated AIs, directors; and can suspend, impose conditions on or revoke authorization of an AI.
- Liquidity and capital support:
  - MA has means and procedures to provide liquidity or capital support to banks for systemic crisis management; such assistance has been provided in the past and is supported by resources from the Exchange Fund.
  - HKMA’s lender-of-last-resort policy is transparent and in line with best international practices, including limiting emergency liquidity assistance to solvent banks and where failure to provide liquidity may result in systemic threat to financial or monetary stability.
  - Other forms of assistance, including capital support, may be provided to protect financial or monetary stability.
  - Although not required by law, MA would, in practice, seek the FS’s approval of any decision to provide capital support (and other funding support in circumstances where the LOLR criteria are not met).

*International Monetary Fund — PEOPLE’S REPUBLIC OF CHINA––HONG KONG SPECIAL ADMINISTRATIVE REGION (excerpts).*

### 49.      The authorities are encouraged to continue efforts to develop a comprehensive

### _cr14130 - 49.      The authorities are encouraged to continue efforts to develop a comprehensive

### Resolution regime for financial institutions
- The authorities are encouraged to continue efforts to develop a comprehensive resolution regime for financial institutions, in line with international practices.
- The MA’s current powers facilitate taking remedial actions or measures to protect depositors of a troubled AI, but there is no comprehensive resolution framework in place that would allow the MA (or other public authority) to stabilize and restructure some or all of a nonviable institution’s business.
- Many of the powers considered necessary under the Financial Stability Board’s Key Attributes of Effective Resolution Regimes for Financial Institutions (including powers to override certain rights, and impose losses on shareholders and creditors) are absent or limited.

### Design considerations for the resolution regime
- Strike an appropriate balance between the role the government plays in financial stability matters (reflecting the constitutional framework) and ensuring the resolution authority has operational independence in carrying out this role.
- Ensure the resolution authority has the capacity to act promptly and decisively; avoid an overly complex legislative framework that could impede timely action.
- Ensure the resources of the Exchange Fund do not limit the imperative that the private sector bears an appropriate share of any costs.

### HKMA recovery and resolution planning
- The HKMA is developing formal requirements for AIs in relation to local recovery and resolution plans.
- After the ongoing consultative process, the HKMA expects to implement the relevant requirements in phases.
- The first group of AIs will have to submit recovery plans in the third quarter of 2014 and resolution plans will follow.
- The HKMA participates in the crisis management groups for the G-SIBs which have significant operations in HKSAR, where much of the work towards recovery and resolution planning for these entities is being undertaken.
- The HKMA proposes to allow local AIs that are part of cross-border groups to draw on their group plan as appropriate to satisfy local requirements.

### Deposit protection scheme — transparency, reliance, and pay-outs
- The deposit protection scheme is transparent and trusted, but steps should be taken to reduce reliance on the Exchange Fund and enhance the efficiency of pay-outs.
- The scheme was introduced in 2006 and has never been triggered.
- The Hong Kong Deposit Protection Board (DPB) uses a variety of channels to enhance the public’s awareness of the scheme and surveys indicate a high level of awareness.
- The scheme is pre-funded through risk-based levies imposed on institutions covered by the scheme.
- Recommendation: The DPB should review the surcharges to replenish the fund after a payout to ensure the private sector assumes appropriate responsibility for costs associated with problem banks.
- Recommendation: To make swifter pay-outs, the DPB should consider changing the present rule of covering deposits net of depositors’ liabilities (as opposed to gross).
- Recommendation: The DPB should seek to formalize the arrangement with the HKMA to make available early warning indicators that provide the DPB with timely notification of bank distress.
- The scheme is prefunded by a yearly fee levied on member banks. The premium varies between 0.0175 percent and

### Cross-border regulatory coordination
- HKSAR’s role as an international financial center generates important cross-border challenges, particularly its position as host supervisor.
- Active engagement with supervisory colleges and CMGs of systemically important institutions—both banks and insurance companies—plays a key role in managing this risk, which is especially important given the dominant role G-SIBs play locally, including their insurance subsidiaries.
- Robust bilateral arrangements exist to facilitate cooperation in the event of any required intervention against a foreign-owned AI; in particular, these provide the legal basis for exchange of confidential information.
- Modes of cross-border oversight and, in particular, resolution, are still evolving; the authorities should remain active in developing best practice in this area.
- Effective cooperation with supervisory authorities in the Mainland is essential to mitigate risks of increased integration; reliance on the Mainland supervisors will be increasingly required as opportunities for cross-selling financial products develop.
- Work underway to deepen the understanding of banks’ Mainland exposures will facilitate a more comprehensive risk assessment.
- To mitigate potential extra-territoriality effects of global regulatory developments, active participation in international fora and strong bilateral engagement should be continued.
- Immediate issue highlighted: central counterparty (CCP) regulation may create potential conflicts of law (between and across the European Market Infrastructure Regulation and Dodd-Frank, and Hong Kong’s Securities and Futures Ordinance) or impact some Hong Kong market participants more negatively than others (e.g., branches of European banks).

*Source: _cr14130 - 49.      The authorities are encouraged to continue efforts to develop a comprehensive*

### 0.0490 percent of the total amount of covered deposits, depending on the risk profile of each bank as measured by

### _cr14130 - 0.0490 percent of the total amount of covered deposits, depending on the risk profile of each bank as measured by

### Deposit insurance and resolution framework
- The target size of the fund is 0.0490 percent of the total amount of covered deposits, depending on the risk profile of each bank as measured by the CAMEL framework of the HKMA.
- The target fund size is noted as comparable to Singapore’s target size of 0.30 percent of covered deposits.
- The fund size determination took into account the estimated likelihood of bank failure, loss given bank failure, and the expected short time-frame to recover funds from liquidators.
- The HKMA participates actively in international regulatory fora and in supervisory colleges and crisis management groups of G-SIBs.

### Timeline of selected macroprudential and property measures (selected entries)
- October 2009
  - LTV ratio capped at 60 percent for residential properties valued at HK$20 million or more.
  - For residential properties valued below HK$20 million, the 70 percent LTV cap continues to apply, but the maximum loan amount is capped at HK$12 million.
- August 2010
  - LTV capped at 60 percent for residential properties with value of HK$12 million or more, and for non-owner occupied residential properties.
  - For residential properties valued below HK$12 million, 70 percent LTV continues, but maximum loan amount capped at HK$7.2 million.
  - Limit on DSRs standardized to 50 percent from a range of 50 to 60 percent.
  - Banks required to stress-test mortgage applicants' repayment ability with an increase in mortgage rates of at least two percentage points, and limit the stressed DSR to 60 percent.
- November 2010
  - LTV lowered to 50 percent for residential properties with value of HK$12 million or more.
  - LTV lowered from 70 percent to 60 percent for residential properties with value between HK$8 million and HK$12 million; maximum loan amount capped at HK$6 million.
  - LTV of 70 percent continues for properties below HK$8 million, but maximum loan amount capped at HK$4.8 million.
  - LTV lowered to 50 percent for all non-owner-occupied residential properties, properties held by a company and industrial and commercial properties regardless of property values.
  - Special Stamp Duty imposed: 15 percent on residential properties resold within 6 months; 10 percent between 6 and 12 months; 5 percent between 12 and 24 months.
- June 2011
  - LTV of 50 percent applied to all residential properties with value of HK$10 million or more.
  - LTV lowered to 60 percent for residential properties with value between HK$7 million and HK$10 million; maximum loan amount capped at HK$5 million.
  - LTV lowered to 40 percent from 50 percent for properties under the net worth-based mortgage.
  - LTV of 70 percent continues for residential properties below HK$7 million, but maximum loan amount capped at HK$4.2 million.
  - Applicable LTV lowered by at least 10 percentage points regardless of property types or values if the principal income of the mortgage loan applicant is not derived from Hong Kong.
- September 2012
  - For mortgage applicants who have already borrowed or guaranteed outstanding property mortgage loans for one or more properties at time of application:
    - Maximum LTV lowered to 30 percent from 40 percent for mortgage loans assessed based on net worth.
    - Applicable cap on LTV lowered by 20 percentage points regardless of property types or values for applicants whose principal income is from outside HKSAR.
    - DSR lowered to 40 percent from 50 percent for applicants who already have an outstanding mortgage on residential, industrial or commercial properties.
    - Accordingly, maximum stressed DSR lowered to 50 percent from 60 percent.
  - Maximum loan tenor of all new property mortgage loans limited to 30 years.
- October 2012
  - Special Stamp Duty raised to 20 percent for residential properties resold within 6 months, 15 percent for resold between 6 and 12 months, and 10 percent for resold between 12 and 36 months.
  - Buyer’s Stamp Duty of 15 percent introduced for buyers of residential properties (except for permanent residents).
- February 2013
  - LTV lowered by 10 percentage points for all commercial and industrial properties from existing applicable levels.
  - LTV for standalone car park space mortgage loans set at 40 percent and maximum loan tenor at 15 years.
  - In stressed DSR calculations, banks required to assume a mortgage rate increase of 300 basis points for all property types.
  - DSR and stressed DSR applicable to commercial and industrial property mortgage loans applied to standalone car park space mortgage loans.
  - Risk weight floor of 15 percent introduced on all new residential mortgages secured on Hong Kong properties granted by banks using the internal ratings-based approach.
  - Ad valorem stamp duty (AVD) rates on both residential and non-residential properties doubled across the board to a maximum of 8.5 percent (except for permanent residents who do not own any other residential property in HKSAR at the time of the acquisition).

### Banking sector soundness indicators (selected figures, 2007–2013/H1)
- Return on average assets: 1.4, 0.6, 0.8, 0.9, 0.8, 0.9, 1.2
- Return on average equity 2/: 23.2, 13.4, 15.4, 15.2, 15.8, 15.3, 15.1
- Interest margin to gross income: 42.8, 57.5, 47.7, 44.0, 45.2, 47.9, 44.2
- Non-performing loans (NPL) as percent of gross loans 5/ 7/: 0.7, 1.2, 1.6, 0.8, 0.7, 0.6, 0.5
- Regulatory capital to risk-weighted assets 2/ 4/: 13.4, 14.7, 16.8, 15.8, 15.8, 15.7, 15.9
- Regulatory Tier 1 capital to risk-weighted assets 2/ 4/: 10.4, 11.0, 12.9, 12.2, 12.4, 13.3, 13.1
- Capital to assets 2/ 5/: 8.5, 7.5, 8.8, 8.6, 8.1, 8.7, 8.8
- Total assets (in percent of GDP) 8/: 627.0, 629.8, 641.0, 691.7, 709.8, 727.7, 704.8
- Residential real estate loans (share of total loans): 19.0, 18.0, 19.7, 17.6, 15.8, 15.7, 14.8
- Commercial real estate loans (share of total loans): 7.6, 8.0, 8.1, 7.0, 6.8, 6.6, 6.4
- FX loans (share of total loans): 26.2, 28.3, 27.0, 33.2, 37.8, 40.1, 42.8
- Customer deposits (share of funding): 56.7, 56.3, 60.0, 55.8, 55.2, 55.8, 55.5

### Macroeconomic scenarios and activity projections (selected)
- Real GDP (2013 est.): 2.96
- Baseline real GDP forecasts (2014–2018): 4.39, 4.37, 4.46, 4.46, 4.51
- Slow Growth (SG) scenario real GDP forecasts (2014–2018): 1.78, 2.66, 2.70, 2.99, 2.95
- Severe Adverse (SA) scenario real GDP forecasts (2014–2018): 1.32, 0.63, 2.38, 2.91, 2.84
- Consumption prices (average CPI) baseline forecasts (2014–2018): 3.67, 3.57, 3.54, 3.53, 3.53
- Residential house prices (baseline and scenarios): baseline 7.97 (2013), projections include negatives and positives across scenarios as shown in detailed tables and charts.
- Memo item: Real GDP (P.R. China) baseline and scenario values: 7.80, 7.70, 7.60, 7.50, 7.50; alternate scenario values include 5.60, 5.52, 6.96, 7.50, 7.44, etc., as tabulated.

### Stress testing framework and results (overview)
- FSAP Macroprudential Stress Test Framework components:
  - Bottom-up by banks: Firms complete own stress tests per IMF-developed guidelines in coordination with HKMA (selected local banks).
  - Enhanced top-down by FSAP team: IMF staff complete balance-sheet-based stress tests with direct prudential data input from sample banks (19 local banks, Group 1).
  - Top-down by HKMA: HKMA staff complete balance-sheet-based stress tests with supervisory data (19 local banks, Group 1).
  - Market-based stress tests (Systemic CCA) by IMF staff for 9 publicly listed local banks.
- Coverage: up to 19 local banks (Group 1) and up to 8 large foreign branches (Group 2) in top-down tests.
- Liquidity tests include: HKMA 7-day/enhanced liquidity tests, implied cash flow tests per IMF guidance, Basel III measures (LCR and NSFR), and market risk–liquidity interaction (Wong-Hui, 2009).
- Stress test assumptions under scenarios (selected):
  - Stressed mortgage rate increase assumption in February 2013 measures: 300 basis points.
  - House price, equity price, unemployment rate, nominal household income, and time deposit rate paths are specified for Baseline, Slow Growth, and Severe Adverse scenarios in graphs and tables.
- Evolution of aggregate capital ratios:
  - Tests report total capital ratio and CET1 ratios across Baseline, Slow Growth, and Severe Adverse scenarios for multiple test approaches (Bottom-up, Top-down IMF, Top-down HKMA, IMF SCCA (ES95%), IMF SCCA (Sum)), compared against the Basel III Hurdle Rate in multi-year charts.

### Liquidity stress tests and vulnerabilities
- Liquidity stress test sample: 19 fully licensed local banks and 8 foreign branches on a Hong Kong office basis, representing 71 percent of the banking sector's total assets.
- Implied liquidity ratio (Wong-Hui, 2009) and HKMA 7-day/Enhanced Liquidity Stress Test (ELST) results are presented for all banks; alternative ELST scenario removes retail deposit run assumption.
- Top-down IMF implied cash flow tests outcomes shown for 5-day test (cumulative), 30-day test (non-cumulative), with alternative scenarios excluding retail deposit runs.
- Funding and structural vulnerabilities highlighted:
  - Loan-to-deposit ratios, total customer deposits/total liabilities, and funding vulnerability metrics presented over time and by institution type.
  - Cross-border claims by counterparty region and sector are reported in billions of HKD for locally incorporated authorized institutions.

### Banking sector vulnerabilities and network spillovers
- Network analysis results:
  - Inward spillovers to Hong Kong SAR banking system capital are dominated by China and the United Kingdom among other jurisdictions.
  - Outward spillovers from Hong Kong SAR banking system show Macao SAR as particularly vulnerable to credit and funding shocks originating in Hong Kong SAR.
  - Charts quantify percentage losses in Hong Kong SAR banking system capital due to distress in other banking systems and vice versa.

*Source: IMF staff and HKMA data and analysis as presented in the document.*

### Appendix I. Risk Assessment Matrix

### Appendix I. Risk Assessment Matrix

### Main threats and likelihood (next 1-3 years)
- Protracted economic and financial volatility, triggered by prospective exit from unconventional monetary policies in advanced economies, particularly the United States, and resulting in increased risk premia and interest rates.
  - Likelihood of realization: High  (short-term)
  - Expected impact on financial stability if realized: Medium
  - Key channels described:
    - Could lead to capital outflows and a tightening of liquidity.
    - Higher interest rates would require borrowers to allocate an increasing proportion of their income to service debt obligations, and encourage banks to tighten credit standards.
    - Resulting contraction in financial intermediation and investment would adversely affect economic growth.

- Sharp slowdown in growth, coupled with significant financial disruptions, in Mainland, in the context of the increasing integration between HKSAR and the Mainland
  - Likelihood of realization: Medium  (short to medium-term)
  - Expected impact on financial stability if realized: High
  - Key channels described:
    - Economic growth in HKSAR would weaken significantly as a result of a sharp economic slowdown in Mainland, with severe consequences for the Hong Kong financial sector.
    - The quality of Hong Kong banks’ assets could be adversely affected as lower growth adversely affect borrowers’—both Hong Kong and Mainland—capacity to repay. This pressure might be further aggravated if the recovery of collateral in Mainland were impeded.
    - Liquidity in the offshore RMB market would be negatively affected by a tightening of liquidity in Mainland.

- Significant decline in property prices
  - Likelihood of realization: Medium  (medium-term)
  - Expected impact on financial stability if realized: High
  - Key channels described:
    - Would reduce the collateral value of mortgages, which would curtain the ability of households and small firms to borrow.
    - In the context of a tightening of banks lending standards, this could have severe macroeconomic consequences and affect banks.

*Source: Appendix I. Risk Assessment Matrix and Appendix II. Summary Stress Testing Matrix (STeM) from _cr14130.*

### Appendix II. Summary Stress Testing Matrix (STeM)

### Types of tests
- Solvency Stress Test: Three complementary approaches: (i) bottom-up (BU); (ii) top-down (TD); and (iii) market-based (MB).
- Liquidity Stress Test: Five complementary approaches: (i) Basel III LCR and NSFR (B3); (ii) HKMA 7-day / LOLR analysis (7-day); (iii) enhanced liquidity stress tests (ELST); (iv) IMF implied cash flow tests (CF); and (v) credit liquidity interaction (based on Wong-Hui, 2009) (WH).

### Who performs the stress tests
- BU: selected local banks
- TD: HKMA and FSAP team
- MB: FSAP team
- HKMA (incl. the IMF CF, for which HKMA uses an IMF template)

### Coverage (banks and share of banking sector assets)
- BU: selected local banks; about 50 percent of banking sector assets (consolidated basis)
- TD (FSAP team): 16 banks; 63 percent of banking sector assets (consolidated basis)
- TD (HKMA): 19 banks; 58 percent of banking sector assets (combined basis)
- MB (FSAP team): 9 banks;54 percent of banking sector assets (consolidated basis)
- B3: selected local banks and foreign branches (solo basis); about 60 percent of banking sector assets (solo basis)
- 7-day, ELST and CF: 19 local banks and 8 selected foreign branches; 71 percent of banking sector assets (solo basis)
- WH: 19 banks; 63 percent of banking sector assets (consolidated basis)

### Description of macro shocks (solvency tests)
- Two alternative macro scenarios:
  - (i) “slow growth” scenario where growth deteriorates to an annual average of 2.6 percent (relative to 4.4 percent in the baseline), residential property prices decline by 30 percent and equity prices decline by 50 percent. Under this scenario, economic growth in the Mainland is assumed to decline to an annual average of 6.6 percent; and
  - (ii) “severe adverse” scenario where growth deteriorates to an annual average of 2.0 percent, broadly similar to the Asian financial crisis experience, and residential property prices decline by 40 percent and equity prices decline by 65 percent. Under this scenario, economic growth in the Mainland is assumed to decline to an annual average of 6.0 percent.
- The scale of these shocks is similar to other FSAPs.

### Description of liquidity stress scenarios (examples)
- 7-day: Bank run, taking into account valuation haircuts to liquid assets.
- ELST: Bank run and dry up of retail / wholesale funding markets, taking into account valuation haircuts to liquid assets and related party lending/ borrowing.
- CF: Bank run and dry up of retail/wholesale funding markets, taking into account valuation haircuts to liquid assets, amortization of outstanding assets, related party lending, and contingent claims/liabilities.

### Risk horizon by test
- BU, TD (FSAP team) and MB: 5 years
- TD (HKMA): 2 years
- B3: 30-day and 1-year
- ELST: 7-day
- CF: 5-day and 30-day
- WH: 1-year

### Risk factors covered
- Credit (including non-default incremental credit risk)
- Counterparty (of off-balance sheet exposures)
- Funding risk
- Market risk (including sovereign risk)
- Market liquidity, funding, maturity mismatch, rollover and FX funding risk

### Metrics reported
- Solvency: Basel III (Common Equity Tier 1, Tier 1, Total Capital, conservation buffer) for each year of the risk horizon
- B3: LCR and NSFR standard metrics (according to BCBS guidance of Jan 2013 and Dec 2012 respectively)
- 7-day, ELST and CF: Hurdle metrics: distribution of ratios, number of failed banks (i.e., ratio<100 percent), liquidity shortfall relative to unencumbered assets
- WH: Expected first cash shortage time (CST), probability of cash shortage (CSP), expected default time due to liquidity problems (LFT), and probability of default due to liquidity problems (LFP)

### Data sources and methodologies
- Data sources:
  - BU: Individual bank’s data
  - TD (FSAP team): Individual bank data collected directly from the banks
  - TD (HKMA): Supervisory data
  - MB: Individual bank data and capital market data
  - 7-day, ELST, and CF: Supervisory data
  - B3 and WH: Individual bank’s data
- Methodology:
  - BU: Banks’ models
  - TD (HKMA): HKMA model
  - TD (FSAP): Balance sheet ST approach
  - MB: Systemic CCA (Jobst and Gray, 2013)
  - B3: Based on BCBS guidance
  - 7-day and ELST: HKMA model
  - CF: FSAP team model (Jobst, forthcoming)
  - WH: Wong-Hui (2009)

*Source: Appendix I. Risk Assessment Matrix and Appendix II. Summary Stress Testing Matrix (STeM) from _cr14130.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14130.pdf_