2005 End-Year Review and Prospects and Priorities for 2006 Hong Kong Monetary Authority 25 January 2006

1 Performance of the banking sector in 2005 (1) Banking system remains in sound condition Pre-tax operating profits recorded healthy growth –increases in both interest income and non-interest income, strong treasury gains, lower credit costs through reduction in bad debt charges and credit recoveries –Growth in operating income out-weighted increase in operating expenses Customer deposits grew by around 3% Domestic loans increased by around 9%

2 Performance of the banking sector in 2005 (2) Overall asset quality (good and improving ) –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 05) 2.25% 0.19% (Dec 05) 0.38% 2.95% (Q3/05) 4.73% 9,000 (Sep 05) 19, % (Sep 05) 15.4% 1.66% (Q1-Q3/05) 1.65% 41.1% (Q1-Q3/05) 41.4%

3 Banking sector issues arising in 2005 Interest rate environment Two-factor authentication Credit card data leakage in the US Second phase RMB business AML/CFT

4 Outlook for the banking sector in 2006 Generally more benign economic environment but challenges remain due to keen competition and uncertain interest rate environment Profitability –Interest margins under pressure, e.g. RMLs –Continuous cost pressure –Positive effects of provisions write-backs disappear Asset growth - Moderate increase in loan demand Asset quality - Steady improvement

5 HKMA priorities for 2006: banking supervision Enhance supervisory information for more effective monitoring of emerging risks, e.g. interest rate risk, of banks Drive for improvement in risk management practices and key business operations through conducting benchmarking review against best industry practices Focus on non-traditional risks, such as those associated with securities, structured products and insurance activities BCP of banking industry in respect of possible outbreak of flu pandemic Strengthen supervisory focus on AML

6 HKMA priorities for 2006: banking policy Basel II implementation is now less than 12 months away (Jan 2007) We are well advanced on the policy framework The Banking Ordinance was amended in Jul 2005 to give the Monetary Authority power to issue “Capital Rules” & “Disclosure Rules”; the drafting of these rules is in hand Hong Kong will be among the first jurisdictions to be compliant with these new international standards, as befits a major international financial centre The improvements in risk management flowing from Basel II will enhance the safety and stability, efficiency and effectiveness of the banking sector

7 HKMA priorities for 2006: banking development (1) Implementation of DPS  development of payout system largely completed  development of rules and guidelines progressing well  review of CAMEL ratings completed Licensing  increased overseas interests to enter the Hong Kong banking market  To increase resources to continue to provide an efficient licensing service without sacrificing prudential standards

8 HKMA priorities for 2006: banking development (2) Securities enforcement concerning AIs  more effort required with growing participation by AIs in the securities market  To devote appropriate resources to ensure efficient enforcement operations  to streamline disciplinary procedures  to continue to liaise with SFC to ensure consistency in enforcement approach

9 Concluding remarks The banking sector remains strong in terms of capital & asset quality Risks & challenges: asset growth; increased competition / reducing margins; exploiting China opportunities; interest rate environment Areas to enhance: strategic direction (consolidation?); income generation / diversification; risk management; corporate governance / management strength Importance of operational / reputational risk DPS and Basel II, both of which are now close, will further enhance the safety and soundness of the banking sector