[PPT] - New Product Risk Management for Mainland Banks Andrew Sheng PowerPoint Presentation

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China Banking Regulatory Commission Market Risk Analysis Seminar

New Product Risk Management for Mainland Banks

Andrew Sheng Chairman Securities and Futures Commission Hong Kong 20 July 2005

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Contents of Lecture

Challenges faced by Mainland banks in moving

towards new products and risk management

Hong Kong experience in introducing new

products, eg warrants, structured products

Regulators’ role in product introduction and

process to manage Risk Management skills of banks issuing such products

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Changing Demographics changes Consumer Demand

Rise of affluent class of savers demands new

range of products, services and wealth management skills

Mainland banks are facing unprecedented rapid

reforms to match best industry practices and international standards

Risk management skills are top priority if

Mainland banks are to compete with increasing foreign banks after WTO opening 2006-2007

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Asian Demographics: Rise in Working Age Group increases savings and demand for new services

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Calculation of Risks

“In making any decision about risk, the logical first step is to try to determine at what point additional risk no longer carries potential rewards that exceed the potential losses, given the respective probabilities of the good and the bad.”

Robert Rubin, former US Treasury Secretary, “In an Uncertain World”, 2003

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Common Corporate Risks

Credit risk
Market risk
Operational risk
Liquidity risk
Legal risk
Regulatory risk
Systemic risk
Political risk
Reputation risk

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3 Major Risks Facing Mainland Banks

Credit risk (80%)

– NPLs – Fraud risk is often tied up with NPLs

Market risk (10%)

– chiefly interest rate risk

FX risk if RMB becomes flexible
Operational risk (10%)

– Internal controls and governance systems still evolving

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Mainland Banks Relying mainly on Interest Income (2004)

0% 20% 40% 60% 80% 100%

ICBC BOC CCB ABC Citigroup HSBC Bank of America UBS

% of Interest Income % of Non-interest Income

Note: figures of ICBC and ABC are for 2003. Sources: Annual Reports of various banks

Unlike major international banks, mainland banks are too reliant on

net interest income, leading to higher credit and interest rate risks.

From a risk management perspective, important to develop non-

interest or fee-based income.

Objective is to find optimal mix of interest income and non-interest

income.

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Loans are important in banks’ asset portfolios (end 2004)

45.2

Bank of America

52.5

HSBC

13.4

UBS

36.2

Citigroup

64.9

Agriculture Bank of China (ABC)

57.0

China Construction Bank (CCB)

48.5

Bank of China (BOC)

64.3

Industrial & Commercial Bank of China (ICBC)

Loans / Assets Ratio (%)

Note: figures of ICBC and ABC are for 2003. Sources: Annual Reports of various banks

Interest income will continue to be the single most important revenue source for Mainland banks. However, there is a need to consider other income sources.

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U.S. Experience – Moving towards fee-based income

Sources: 40/2004 Economic Perspectives, “How do banks make money? The fallacies of fee income”, Federal Reserve Bank of Chicago

In the early 1980s, the ratio of interest income to fee- based income for U.S. commercial banks was 8:2. This ratio has increased to 6:4 since late 1990s.

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Deregulation: commercial banks are allowed to

engage in other financial services, e.g., investment banking, securities brokerage, insurance agency, asset management, etc.

Strategic decision by banks to diversify revenue

sources and to identify new fee-based income from traditional banking services, e.g., deposit account services, trust account/wealth management services, loan origination and services, credit cards, etc.

Advances in technology enhance service quality

and increase customer convenience, allowing banks to charge for such services separately.

The shift to fee-based income has been driven by

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Mainland banks already have large exposure to NPLs from

traditional banking services, because credit risk management still remains weak.

Not all major foreign banks succeed well in moving into non-

traditional fee-generating activities (e.g., proprietary trading, securities brokerage, sale of various financial products).

This requires complete change in core competencies and

staff training – from document processing (eg loan evaluation and due diligence) to customer service quality, marketing and managing compliance and back-office processing for wealth management products

Moving towards Fee-based Income requires complete re-engineering of the workflow of banks, creating new risks

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Fee-based income is knowledge-based service, with need

for core skills in:-

– Marketing and Sales – Distribution Channel Management – Execution of sales [eg insurance, credit care, wealth management products] – Product development – Risk Management – Compliance and back-office controls

Fee-based income also requires cross-selling, which means

not only changes in documentation, accounting and reporting, processes and complete re-writing of IT software, including hardware configuration.

This explains why re-engineering costs in many foreign

banks are very high and not all succeed

Need to develop totally new core skills, with tremendous shortage of such skills in Mainland

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HK Experience – Banks’ Expansion into New Financial Products

In Hong Kong, commercial banks are permitted to engage in
ther financial services – securities, asset management,

insurance, etc.

The larger ones have taken advantage of the opportunity to

design and package new financial products, including new channels (eg Internet banking) to meet the needs of investors and customers and to open new revenue sources.

Besides the traditional interest rate or foreign currency

related products, many have recently expanded into equity- related products, in particular, the derivative warrants and structured notes markets.

Banks are finding that training staff to understand new lines
f products and new regulations not easy to manage.

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HK Advantage – Banks can take care of themselves in introducing New Financial Products

In Hong Kong, the regulators leave the commercial banks to

look after themselves in all areas of due diligence, systems and staff training when they wish to launch new products.

On specific products, eg banking, insurance, Mandatory

Provident Fund, securities, bonds, they have to apply to the relevant regulator to ensure that the product is legally approved for sale in Hong Kong

Each HK regulator approves such product according to

different laws and regulations. Unless the license forbids the bank or broker from engaging in the sale of such products, we generally assume that the bank or broker can take care of its risks, unless our specific audit or inspection tells us otherwise.

We would soon know whether there are problems if there

are sufficient consumer complaints about quality of service.

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HK Experience – Derivative Warrants

Total issue size in 2004 was about US$18 billion (accounting

for about 27% of total funds raised in 2004)

In Q1 2005, total issue size was US$4.2 bn (the amount of

equities funds raised in the same period was US$3.8 bn)

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Most active issuers of derivative warrants in Hong

Kong are European commercial banks, e.g., SG, KBC and BNP (HKEx was the most active derivative warrants exchange in the world in 2003 and 2004).

In 2004, European commercial banks issued 750+

derivative warrants in Hong Kong, raising a total of about US$9.5 bn.

The number of issues was about 60% of the market

total, whilst the aggregate issue size was about 53%

f the market total (the rest was mainly issued by

investment banks).

Banks’ Participation in Derivative Warrants

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Structured notes are increasingly complex (e.g. with

a knockout feature or linked to a basket of stocks).

The issue size of structured notes including both

retail and wholesale markets appears large (around US$10 bn per annum according to market estimate).

Structured notes are mainly issued through private

placement, but becoming more popular for retail investors (selling through the commercial banks’ retail network).

The private banking area is not regulated by HKMA

nor SFC, because it is assumed to be high net-worth customer area.

HK Experience – Structured Notes

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Market Risk – Financial Derivative Products

Derivatives with option-like features (e.g. derivative

warrants, equity-linked structured products) are trading volatility.

Issuers of these products need to use the underlying

equity market to hedge their positions. Whether the liquidity of the equity market is sufficient to accommodate such hedging activity is critical to the risk management of the products and market stability.

Regulators need to strengthen infrastructure to

facilitate hedging activities by issuers:

– Allowing (covered) short selling in the stock market is important to issuers of financial derivative products for risk management purposes – Promoting stock borrowing and lending market (a prerequisite for short selling) is necessary

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Bank Risk Management

RM is a process, a series of actions– not merely one event
r one action, as banks’ operate in an uncertain

environment

RM is people-based — not merely policies, procedures or

models, but involves people at every level of a bank. Ultimately risk management is all about judgment of people with skills

RM is applied within a Strategy Setting. The RM policy

serves bank strategy and is also a part of bank strategy

RM cuts across the whole bank—considered at all levels,

from bank-level activities such as strategic planning and resource allocation, to business unit activities such as marketing and human resources, to business processes such as documentation and new customer credit review

RM must try to identify events potentially affecting the

banks and manage risk within its defined risk appetite

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Risk Management = Corporate Culture

RM is a part of overall corporate governance
Effective RM requires:

– Sound corporate governance

Board of Directors must understand risks facing the bank,

its risk tolerance level, with clear risk policy – Appropriate RM philosophy

How to evaluate the value of RM, e.g. as a cost or a profit

centre – Risk culture

A set of common attitudes, value and methodologies,

reflecting how to treat the risk in daily activities

A uniform culture needed. A mismanaged bank often

demonstrates different, even conflicting risk cultures – Risk culture, corporate governance, business ethics, and transparency can not be separated from each other

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Managing Risks for the Consumer

Do you know the product you are buying?
Do you know the risks associated with the

product? If not, ask for professional advice.

Do you know how much risk you can assume?

– Do not put all your eggs in one basket – Customer suitability issue – should not take risks that may not have ability to absorb such risks, eg retiree investing in high risk stocks

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Managing Risks for the Bank

Can you identify the risks?
Can you measure such risks?
Can you control such risks?
Do you have the systems to hedge or manage

such risks?

– Have you properly accounted and reported such risks regularly?

– Do senior management understand what these risks are? – Do you have sufficiently qualified staff to manage the sophisticated risk models and risk control systems?

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Guidelines on Managing Market Risk

In recent years, the CBRC has issued a number of

rules and guidelines:

– Interim Rules on the Administration of Derivatives Trading Business by Financial Institutions – Guideline on commercial banks' market risk management – Regulation on the assessment of the internal control system in the commercial banks

It is also important for the regulators and the market

to work together to develop the necessary market infrastructure (e.g. trading platforms) and risk management instruments (for both OTC and exchange traded) to enable banks to manage their risk properly.

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Recent New Products in Mainland

By end-2004, 7.7 billion bank cards have been issued,

including debit cards, quasi-credit cards and credit cards

Derivatives offered by Mainland banks include futures,
ptions, swaps, forwards, etc, with a combined

transactions value of RMB 300 billion.

Wealth management business includes now more

than 100 new products within 20 categories being

ffered in last two years.

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Tips on Using VAR Models

The VAR Models are only as good as:-

– The data which is fed into the model – The key assumptions used in the model – A good understanding of what the model is telling you about the risks being assumed

Do not use VAR model as only test of the exposure of

market risks – in Emerging Markets, volatility can be much higher than in Mature Markets.

LTCM failed because the models assumed 4 standard

deviations of market movement, when actually the market moved 15 standard deviations

Hedging market risks can result in large counter-party

risks

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Banks’ Participation in Financial Derivatives in the Mainland Market

According to the statistics of the CBRC, at the end of

1Q 2005, 16 mainland banks and 37 foreign banks have been approved to participate in financial derivatives business.

At present, foreign banks are the major issuers of

financial derivative products in Mainland. More mainland banks are launching their own financial derivative products to capture this business.

At this stage, most of the financial derivatives offered

by banks in Mainland are linked to foreign exchange and interest rates, but their structures have become more and more complex (e.g. structured products).

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Risk Management is ultimately a Governance Problem

Banks must be able to develop the sophisticated

governance system to identify, manage and hedge most of their risks.

In the Mainland, the shortage of skills, and senior

management who understand the need to manage such risks, is the highest risk.

This is also critical at the regulator level, because such

risk management skills are expensive to hire and require experience and exposure.

Risk is that a learner cannot regulate another learner

effectively

Important that CBRC devote substantial resources to

train skills in this area.

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Policy Considerations

At present, banks in the Mainland are not allowed

to engage in securities business.

If banks are involved in wealth management and

sale of insurance through their private banking or branches, it is inevitable that banks would be handling products that are subject to other regulators and also need to develop skills and knowledge of laws and regulations in these product fields.

Hence, from a macro policy standpoint, the issue
f “lead regulator” or sharing of regulatory

function will have to be considered in the event that banks widen their scope of their business.

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Practical Regulatory Issues

Important that Mainland banks wishing to enter

into new products must demonstrate the ability to manage such systems.

Must recognize that large costs are involved in

staff-training, re-engineering, and process

change. Mistakes will be made.
May be important to make sure that Mainland

banks have strong strategic partners with good skills and technology to assist this re-engineering

Important to ensure that new products are piloted,

before full-launch

Regulator needs to ensure that proper

governance structure exists to manage these new product risks

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Malcolm Sparrow - The Regulatory Craft

“Pick important problems, fix them and then

tell everybody.” “The essence of the [regulatory] craft lies in picking the right tools for the job, knowing when to use them in combination, and having a system for recognizing when the tools are inadequate so that new ones can be invented.”

Professor Malcolm Sparrow, The Regulatory Craft, Harvard University

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Policy Option Matrix--- Who Gains, Who Lose？

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Concluding Thoughts

New product launches bring new sources of

revenue, but also new types of risk (e.g. relating to the equity market).

Banking supervisors should ensure proper

management of the new market risks.

Adoption of international best practices is the

key.

Both bank staff education and investor

education is crucial to success of such launches.

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