Hong Kong Banking Sector: 2007 End-Year Review and Prospects and Priorities for 2008 Hong Kong Monetary Authority 5 February 2008

1 Performance of the banking sector in 2007 (1) Banking sector remains highly liquid, well capitalised and profitable Bolstered by strong fund raising activities in the stock market, deposit growth was strong (deposit for all retail banks +19.5% for Q1 to Q3 2007) Domestic loan growth was strong and broad based Net interest margins improved amid sharp increase in operating costs Strong profit growth in the first nine months of 2007, as increases in both interest and non-interest income more than offset higher operating costs, and momentum continues in Q However, profitability of individual bank may be affected due to exposures to subprime-related exposures or the widening of credit spread

2 Performance of the banking sector in 2007 (2) Overall asset quality (good) –Classified loan ratio –Mortgage delinquency ratio –Credit card charge-off ratio (annualised) –No. of negative equity mortgages Average consolidated CAR Net interest margin (annualised) Cost-to-income ratio % (Sep 07)1.11% 0.11% (Dec 07)0.20% 3.10% (Q3 / 07) 2.91% 1,900 (Dec 07)8, % (Sep 07)14.9% 1.86% (Q1-Q3 07)1.80% 39.9% (Q1-Q3 07)42.7%

3 Banking sector issues arising in 2007 (1) Uncertainty in the interest rate environment Subprime: no systemic issue for local banking sector. But monitoring impact on individual banks and contagion effect on Hong Kong’s economic growth and asset markets Intensifying business competition associated with high level of liquidity and pressure on yield enhancement Increasing operating costs

4 Major Work in 2007 Increasing contributions of share finance and incomes to loan portfolios and earnings Close monitoring of stability and utilisation of AIs’ Internet banking, including on-line securities trading systems Strengthening security controls over high-risk Internet banking transactions, e.g. using SMS confirmation Banking sector issues arising in 2007 (2)

5 Outlook for the banking sector in 2008 (1) Challenges remain due to keen competition, impact of subprime and volatilities in global financial markets Risks and challenges –1st wave impact of subprime still filtering through the system –2 nd wave impact of subprime on global economy and financial markets –Macroeconomic adjustments in the Mainland may increase market volatility –Credit quality may worsen –Implementation of Basel II Review of the HKMA’s work on banking stability –Aims to make recommendations on focus and priorities of the HKMA’s banking supervisory functions and policies to be developed in the next five years or so Outlook for the banking sector in 2008

6 Banking Supervision - Priorities for 2008 Continue to closely monitor the impact of US subprime fall-out on individual AIs Lending Business –Monitor the asset quality of individual AIs and review the adequacy of their systems in managing credit risk –Review AIs’ control against misuse of credit facilities for speculative purpose Continue to monitor AIs’ control over AML/CFT through regular on-site examinations and off-site surveillance Technology Risk Management –To ensure AIs have adequate resources for capacity planning for Internet banking and online securities trading systems –To work with HKAB and the Hong Kong Police Force to develop effective customer education programme to promote sound control practice and awareness of emerging fraudulent techniques on Internet banking Banking Supervision – Priorities for 2008

7 Banking Supervision - Increasing trend of reported fake websites Observable increase (59%) of reported cases of fake bank websites in 2007 Although no financial losses reported since the launch of 2FA, this trend deserves attention: global decrease in cost in generating fake websites 2FA remains effective in Hong Kong but customers should remain vigilant in protecting their personal and sensitive information Bank customers are reminded that banks will NOT ask sensitive information from customers such as passwords by , phone or in person Step up customer education programme in 2008 Banking Supervision – Increasing trend of reported fake websites No. of fraudulent s & fake websites 2FA introduced in mid

8 Banking Supervision – Basel II implementation Significant resources devoted in 2007 to process applications by AIs to migrate to more advanced approaches 4 AIs approved to adopt IRB approach for credit risk following extensive validation examinations in 2007 A structured process established for review of applications to adopt Standardized Approach (STO) or Alternative Standardized Approach (ASA) for operational risk. 10 validation examinations of AIs conducted in 2007 First round of Supervisory Review Process on local AIs under Pillar II completed in 2007 Continue to process Basel II applications in 2008 Review enhancement to risk management practice after adoption of Basel II Banking Supervision – Basel II implementation

9 Banking Policy - Developments in 2007 Monitoring and assessment of impact of Basel II implementation –Capital and Disclosure Rules came into effect on 1 Jan 2007 –Supplementary guidance provided to facilitate understanding of the Rules –Risk-based supervisory system further enhanced through implementation of supervisory review process under Pillar 2 AML/CFT continued to be a major supervisory focus –Assisted Government in FATF Mutual Evaluation –Industry Working Group (IWG) produced 3 guidance papers –Strengthened resources of specialised examination teams CCRA ready to cover sole proprietorships and partnerships from 1 Mar 08 Developed supervisory guidance on strategic risk / reputation risk management Banking Policy – Development in 2007

10 Banking Policy - Initiatives for 2008 Basel II –Ensure framework is up-to-date and appropriate in light of implementation experience and developments in international standards –Refine supervisory review process and consider further guidance on CAAP (i.e. capital adequacy assessment process) –Monitor AIs’ readiness for adopting more advanced approaches, e.g. for counterparty credit risk (CCR) and operational risk AML/CFT –Further enhance framework taking into account recommendations arising from FATF Mutual Evaluation –Assist IWG in producing practical guidance on topical AML/CFT issues –Continue more in-depth institution-specific and thematic AML/CFT examinations Review of liquidity regime in light of recent market events Develop supervisory guidance on CCR management and consolidated supervision Complete second review of Code of Banking Practice Banking Policy – Initiatives for 2008

11 Banking Development - Key achievements in 2007 (1) Securities Enforcement Completed investigation into 13 cases and made recommendations to the SFC to exercise powers to discipline and/ or issued warning letters to the registered institutions (RIs) and relevant individuals (ReIs) concerned Took disciplinary action under section 58A of the Banking Ordinance, the first of its kind, to suspend the particulars of an ReI from the HKMA’s register Increased the frequency of meetings with the SFC on enforcement matters from twice yearly to quarterly, and revised the side letter to the MOU in April Banking Development – Key achievements in 2007(1)

12 Banking Development - Key achievements in 2007 (2) Customer Complaints Handled 469 customer complaints about banking services or products in 2007, compared with 292 in 2006 Octopus Reviewed the market structure of multi-purpose stored value card Explored with Octopus Card Limited (OCL) and other relevant parties on possible ways to promote competition Licensing Number of licensed banks increased to 142 Banking Development – Key achievements in 2007(2)

13 Banking Development - Key achievements in 2007 (3) Deposit Protection Scheme Assisted the Hong Kong Deposit Protection Board in implementing the Deposit Protection Scheme (DPS) in the first year of its operation - formulated a number of mechanisms for monitoring Scheme members’ compliance with DPS rules and guidelines - conducted simulation tests and a payout rehearsal to enhance the readiness of the DPS to payout -achieved a high level of public awareness (about 70%) of the DPS The average growth rate of relevant deposits recorded by small to medium-sized local retail banks in 2007 was around 10%, as compared to 6% recorded by the large retail banks and the industry average of 8% Banking Development – Key achievements in 2007(3)

14 Banking Development - Priorities for 2008 Review the relevant rules and regulations and resources available for the enforcement functions in response to the expanding scale of RIs’ securities and futures business Work with OCL to open up the card issuing businesses Continue to maintain an efficient licensing application process without sacrificing prudential standards Continue to assist the Hong Kong Deposit Protection Board to operate the Deposit Protection Scheme –Implement mechanisms to enforce DPS rules and guidelines –Enhance payout readiness through simulation tests and a payout rehearsal –Continuously refine the payout system and processes –Undertake on-going publicity activities to maintain and enhance public awareness and understanding of the DPS Banking Development – Priorities for 2008

15 Concluding remarks Banking system remains strong but should not lose sight of challenges due to intense competition and potential volatilities in global financial markets as a result of subprime fall-out and possible economic slowdown in US and the UK AIs should remain prudent in loan underwriting and to ensure that the uses of loans are consistent with the borrowers’ declared loan purposes, instead of other purposes Successful launch of Basel II while looking forward to further refinement of the framework Further enhancement of the operation and public understanding of the Deposit Protection Scheme Concluding remarks

Q & A

Reference Slides

18 Liquidity and Loan-to-Deposit Ratio of all retail banks Sep 2007Dec 2006 Liquidity Ratio : 51.0% 50.7% (quarterly average) Loan-to-Deposit Ratio : HK Dollar 67.1% 69.1% All currencies 48.6% 47.9%

19 Domestic loan growth of all retail banks for Q1 to Q Domestic loans for all retail banks: % Of which : Property lending: + 6.9% Share finance: + 1,617.7% Trade financing: % Manufacturing: % Wholesale & retail trade: + 6.5%