International Journal of Law and ManagementBanking crises and Hong Kong: coordination between regulatory measures and compensation schemes(bailout, deposit insurance and insolvency laws)Eva K.Y. Kan Mahmood Bagheri

Article information:To cite this document:Eva K.Y. Kan Mahmood Bagheri , (2015),"Banking crises and Hong Kong: coordination between regulatory measures andcompensation schemes (bailout, deposit insurance and insolvency laws)", International Journal of Law and Management,Vol. 57 Iss 3 pp. -Permanent link to this document:http://dx.doi.org/10.1108/IJLMA-02-2014-0013

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Banking crises and Hong Kong: coordination between

regulatory measures and compensation schemes

(bailout, deposit insurance and insolvency laws)

1. Introduction

The collapse of the internationally active bank Lehman Brothers Holdings Inc.

(‘Lehman Brothers’) was one of the key triggers for a massive financial crisis globally

in 2008. The detrimental impacts have been spread internationally through the inter-

connected financial markets. Many government actions and policies were ineffective.

(Krugman, 2008; Mishkin, 2011; Taylor, 2009) This paper suggests that international

cooperation among national supervisory authorities and the coordination between ex

ante regulatory measures and ex post compensation schemes are crucial in response to

the global banking crises and to deal with too-big-to-fail issue on trouble banks like

Lehman Brothers. Hong Kong is an international city in which many branches of

globally systematically important banks are located. Cooperation with their

headquarters in other countries becomes significant in the event of banking crises.

This paper argues that not only should a comprehensive legal and regulatory

framework be set up in line with international standards, but also this puts emphasis

on the harmonious relationship between the adoption of ex ante regulatory measures

and ex post compensation schemes. Major types of ex post compensation schemes

will be examined – bailout, deposit insurance and insolvency laws.

In addition, the choice of Hong Kong as a context is an additional novel aspect of

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this paper. Problems appeared in the existing Hong Kong financial regulatory system

after the financial crash in 2008. This paper analyses them according to the Reports

given by Legislative Council of Hong Kong, Hong Kong Monetary Authority and

Securities and Futures Commission, in which lack of coordination and cooperation

between the authorities was highlighted as one of the major problems. This paper will

analyze if it is well prepared as an international financial centre with its close

connection with Mainland China against future banking crises. The paper concludes

with suggestions given to governments, regulators and other relevant practitioners in

both developed and developing countries.

2. Literature review

Mishkin (2011) explained the collapse of Lehman Brothers is one of the key

triggers to the recent financial crisis in 2008. The contagious effect of such crisis

recognizes how the global financial system is highly interconnected. Krugman (2008)

and Taylor (2009) hold the view that many government actions and monetary policy

were ineffective during the crisis. Literature has pointed out that the national response

to a collapse of a globally systematically important bank was not sufficient against

banking crises and showed the significance of international cooperation between

supervisory authorities of the affected countries. (Arner, 2009; Brummer, 2010;

Bryant, 2008; Lord Turner, 2009) The rationale behind of such cooperation is

illustrated by Katada (2013): the strong economic linkage and the anticipation of

getting adequate intangible returns such as financial stability and bilateral trading

relationships among countries are the strong motivation to take actions in crisis

management and to cooperate with each other to maintain the financial stability.

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Lastra (2003) illustrates the legal implications in cross border bank insolvency

which suggest the financial groups form a single economic entity. Parent banks and

home supervisory authorities should monitor their branches or subsidiaries located in

other countries. This implication can also apply in cross border bank insolvency. Even

though Hong Kong has close relationships with international organizations, such as

Financial Stability Board and Basel Committee on Banking Supervision, Arner (2010)

points out that Hong Kong still lacks crisis management scheme for banks and also

highlights the weakness of the deposit insurance scheme in dealing with failure of

financial institutions.

The common forms of ex post compensation schemes for banking crises are

bailout, deposit insurance and bank insolvency. Miron (2009) argues that government

bailout was the most important cause of the 2008 financial crisis and criticizes it as an

inappropriate use of taxpayer money. It also triggers the issue of moral hazard which

eventually encourages a higher loss. Block (1992) suggests a special bailout policy,

which can balance the advantage of the bailout and its consequence in order to

achieve the best interest of the public.

Large part of the literature underlies the idea that deposit insurance is a positive

measure to reinforce the public confidence and thus it can minimize the effect of bank

runs. A few segments of the literature point out that such stabilizing effect could

hardly be lasted in the long run in case of full coverage of insured deposits, which is

prone to moral hazard. Onder and Ozyildirim (2008) suggests that the coverage limit

affects the effectiveness of the deposit insurance scheme. The coverage limit should

be established in covering most small depositors while the large depositors are

encouraged to monitor the bank activities.

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A special resolution regime for banks is necessary to liquidate troubled banks in

a way of protecting the public interest. Hüpkes (2005) suggests that a bank is a special

institution, which should be treated differently from other corporations as it has a

significant function and impact on the socio-economic development of the society.

However, the resolution power authorized under a special resolution regime has to

strike a balance with the supervisory power. Kawai et al. (2012) uses Korea as an

example of showing a serious issue of conflict of interest occurring in the authority

which is endowed with both the powers of supervision and resolution on financial

institutions.

The link between using the supervisory power and resolution power has been

indicated in Giani (2010). It points out that when developing a reform of crisis

resolution measures, the authority has to consider carefully the complementarity

between ex ante financial supervision and ex post crisis resolution. Further, Alexander

(2013) points out that the effective way to help the financial institution in distress is to

provide a seamless process between the adoption of ex ante supervisory measures and

ex post crisis management measures. Mayes (2005) identifies the difficulty of balance

between regulatory laws and compensation measures such as bankruptcy laws. It

discusses the issue of the losses from bank insolvencies and their avoidance through

intervention by resolution authorities. It suggests by way of such coordinated scheme

which would allow the distribution of losses among creditors, depositors, owners and

the population at large in transition and emerging economies. Nevertheless, Frankel

(1998) argues that emerging markets often lack well-developed and well-structured

bank bankruptcy regimes. Such conceptual framework linking both international

cooperation and also coordination between ex ante regulatory measures and ex post

compensation schemes, unique to the current paper, has not been substantially

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touched upon in the existing literature.

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3. The Readiness of the Hong Kong Regulatory Structure

to Face International Banking Crises

The crises which have happened in Hong Kong are usually triggered by banks in

foreign countries, for instance, the Asian financial crisis and the recent 2008 financial

crisis. A financial crisis is a complex issue that is comprised of financial market,

government policy and economic conditions. It is even more complex when it gains

an international dimension. Therefore, robust regulation and good policy are required

to combat the financial crises. After the 2008 financial crisis, it is observed that Hong

Kong financial regulatory system has gaps and flaws that contribute to a demand for

improvement. The subcommittee (Legislative Council of the HKSAR, 2012)

investigated the recent financial crisis and referred to the Review reports from Hong

Kong Monetary Authority (‘HKMA’) (Hong Kong Monetary Authority, 2008) and

Securities Futures and Commissions (‘SFC’) (Securities and Futures Commission,

2008). They highlight the weakness of the Hong Kong financial regulatory system in

the face of financial crises originated in other countries.

3.1. Examination of the Hong Kong financial regulatory system

After the crash of 2008 financial crisis in Hong Kong, problems and weakness

of the current financial regulatory system have been clearly appeared. The financial

institutions are regulated in accordance with the kinds of activities conducted. The

major problems are the unclear accountability of the regulators towards the Relevant

Individuals (‘ReIs’) who are under the banks’ employment to carry out regulated

activities (Legislative Council of the HKSAR, 2012), and the ineffective arrangement

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between the regulators in Hong Kong on supervising the ReIs’ activities.

The HKMA, which acts as a central bank in Hong Kong, is responsible for

supervising, detecting, and investigating any authorized institutions (“AIs”), such as

banks non-compliance with regulation. It also supervises regulated activities including

securities trading according to the rules and requirements set by the SFC. The SFC

has the power to impose disciplinary sanctions on AIs and ReIs for their regulated

activities under the Securities and Futures Ordinance [1] (‘SFO’). However, neither

the HKMA nor the SFC has the power to investigate and regulate directly ReIs.

Unclear division of work on supervising ReIs is one of the regulatory issues to be

concerned about.

Nevertheless, in the present enforcement framework over the ReIs’ conduct of

regulated activities with the exercise of regulatory powers by the HKMA and the SFC,

the HKMA oversees all the activities of banks, while the HKMA is vested with

statutory power to investigate suspected breaches of the Code of Conduct and other

regulatory requirements. Yet, it does not have the power to impose sanctions on AIs.

Such power is exercised by the SFC under SFO after the consultation with the HKMA.

(Legislative Council of the HKSAR, 2012) Thus, these operational complexities are

not helping effective enforcement.

HKMA and the SFC made suggestions after reviewing the current regulatory

structure. The HKMA suggested a practical way in strengthening its power in the

regulatory framework while the SFC recommended a structural change. (Hong Kong

Monetary Authority, 2008) (Securities and Futures Commission, 2008)

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At present, the responsibility of supervising Als’ securities activities is shared

between the HKMA and the SFC. (Carse, 2009) The HKMA therefore recommended

that all aspects of Als’ securities business should be placed under the HKMA,

including registration, standard-setting, supervision, investigation and sanction. (Hong

Kong Monetary Authority, 2008) The coordination between the HKMA and the SFC

should be strengthened to set consistent standards of conducts. (Hong Kong Monetary

Authority, 2008) The subcommittee report also supported and proposed that if the

HKMA had had the power in enforcing the regulatory requirements of the conduct of

regulated activities, cases of mis-selling relating the Lehman-Brothers structured

products to inappropriate investor could have been reduced. (Hong Kong Monetary

Authority, 2008)

The SFC observed that the institutional regulatory structure is no longer

optimal. It recommended that the Government should consider if the present financial

regulatory structure is suitable for facilitating its development and preventing future

financial crises. (Securities and Futures Commission, 2008) the SFC proposed a

“Twin Peaks” approach (Securities and Futures Commission, 2008) where financial

stability regulation and prudential regulation are enshrined in a single body, while

another separate body is responsible for the supervision of the financial product and

financial market conduct. (Taylor, 1995)The SFC thus recommended the Government

make a full regulatory review which has already been initiated by the Financial

Secretary.

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3.2. Hong Kong Financial Regulation: Necessity of Bank Crisis

Management in Hong Kong?

Hong Kong has an important role in the development of international financial

standards. For instance, Hong Kong is a member of Financial Stability Board. Hong

Kong is required to align its regulations with the international regulatory changes as it

aims to prevent further occurrence of the global financial crises. It could be suggested

that Hong Kong has met international standards, as the HKMA has always been

keeping pace with these standards. For instance, most of the banks in Hong Kong

have reached more than the required eight percent capital ratio recommended by the

Basel Committee on Banking Supervision. (Hong Kong Monetary Authority, 2013)

But, on the contrary, Hong Kong’s financial system has at times proved unable

to avoid or effectively deal with bank failures. Moreover, after the collapse of Lehman

Brothers, Hong Kong still lacks a comprehensive compensation scheme, which

includes a special crisis management mechanism to deal with banks or financial

groups’ failure. (Arner et al., 2010) Therefore, it is suggested that Hong Kong should

take initiative in improving the financial regulatory structure with respect to the

international standard, rather than taking a reactionary approach as a result of crisis.

(Arner et al., 2009)

3.3. Domestic Coordination among Supervisory Regulators

Regulatory measures are effective provided that the enforcement system and

supervision are efficient and sufficient. A proper coordination is necessary and crucial.

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In Hong Kong, for the sake of increasing the linkage between regulators from various

sectors, the Council of Financial Regulators (‘CFR’) and the Financial Stability

Committee (‘FSC’) were established. The CFR, which is chaired by the Financial

Secretary, focuses on minimizing the regulatory gaps or duplications among the cross-

sector regulatory matters. The FSC, which is chaired by the Secretary for Financial

Services and the Treasury, is responsible for the monitoring of the financial system

and developments. (Hong Kong Monetary Authority, 2006)

In addition, a Memorandum of Understanding (‘MoU’) was signed between

regulators in order to enhance the cooperation. The MoU between the HKMA and the

SFC set out the roles and responsibilities of their major functional aspects in the

regulatory regime, exchange of relevant information and notification or referral of

relevant matters. (Hong Kong Monetary Authority, 2006) However, it is not legally

binding. To foster the coordination in enforcing the provisions in MoU, regulation

must come into play to strengthen the coordination between regulators. For instance,

in the United Kingdom, legislation has strengthened the coordination between the

Financial Conduct Authority (‘FCA’) and the Prudential Regulation Authority (‘PRA’)

in fulfilling their functions and responsibilities under the statutory MoU between them.

(HM Treasury, 2011) Both regulators have the statutory obligation to consult and

interact with each other in an efficient and non-duplicative way, as well as the

coordination with international and European regulatory bodies. For instance, the

PRA has the power to prevent the FCA from taking actions if it considers they might

lead to the disorderly failure of a firm or promote wider financial stability. Such veto

power has to be transparent and in consideration of public interest. (HM Treasury,

2011)

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3.4. International Cooperation among Supervisory Regulators

The historical lesson of the 2008 financial crisis shows the responses against

the crisis were national and uncoordinated. International cooperation with regulatory

supervisors of different jurisdictions is very important in consideration of the

numerous foreign establishments of banks’ subsidiaries and branches operating in an

international city such as Hong Kong. The rationale behind such cooperation is

illustrated by Katada (2013). Mutual benefits between the countries would be gained.

For instance, strong economic linkage and the anticipation of getting adequate

intangible returns such as financial stability and bilateral trading relationship among

countries. They are the strong motivation to take actions in developing crisis

management and to cooperate with each other in maintaining the financial stability.

Realizing that the financial markets are highly interconnected, it is necessary

to set up a platform to address the interdisciplinary nature of the financial crisis.

(Brummer, 2010) In the European Union (‘EU’), a Supervisory College is established

for each financial institution with branches or subsidiaries operating in more than one

member state. Home and host authorities in a college coordinate and cooperate jointly

and exchange information for ongoing supervision on the banking group and in

handling of emergency situations. (European Banking Authority, 2013) Recent revised

principles for effective supervisory colleges, in June 2014, provide guidance on the

communication and coordination between the college and the Crisis Management

Group in preparing recovery and resolution plans. (Bank for International Settlements,

2014)

In Hong Kong, the financial supervisory authority, the HKMA, views that the

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supervision of foreign branches or subsidiaries is the joint responsibility between host

and home supervisors according to the Basel’s Committee’s Core Principles for

Effective Banking Supervision. (Hong Kong Monetary Authority, 2002)The HKMA

relies heavily on the cooperation of other foreign supervisors to ensure effective

consolidated supervision of banking groups. Such cooperation involves information

sharing and sharing of supervisory responsibilities. The principle of consolidated

supervision, as explained in the “Principles for the supervision of banks’ foreign

establishments” set up by the Basel Committee, is that parent banks and home

supervisory authorities monitor the risk exposure and capital ratio of their respective

banks and banking groups. (Basel Committee on Banking Supervision, 1983) This is

based on the assumption that financial groups form a single economic entity. (Lastra,

2003)

On the other hand, the branches of foreign banks have to follow certain rules

the same as locally incorporated banks on statutory liquidity ratio and on-site

examinations by the HKMA. They also have to submit returns for their Hong Kong

operations, but there is no capital-based supervisory requirement. (Hong Kong

Monetary Authority, 2002)

In short, the preventive regulatory measures require a comprehensive financial

regulatory structure and a close cooperation and relationship between the local

regulators, foreign regulators, and international organizations. Hong Kong’s financial

regulatory structure is required to be reviewed regularly. The cooperation between the

HKMA and the SFC needs further improvement in monitoring the behavior of the

financial institutions. More cooperation has to be attained in order to monitor and

enforce the international standards and to achieve a stable and healthy global financial

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market. (Bryant, 2008)

4. Ex post Compensation Schemes – Bailout, Deposit

Insurance and Insolvency Laws

When ex ante regulatory measures cannot afford the proper protection for the

investors and depositors against the crises, particularly in an international context, a

comprehensive ex post compensation scheme should act as a strong shield in

maintaining public confidence in the financial market. However, it has to be kind of

harmony between the regulatory measures and the compensation schemes. The

common forms of ex post compensation schemes for banking crises are bailout,

deposit insurance and bank insolvency laws.

Bailout is often used by the government as a way to save the troubled financial

institution, it is neither a long term solution nor solving the root of the problem.

Excessive use of this scheme creates the moral hazard which encourages the violation

of banking and securities regulations. Deposit insurance scheme guarantees the

certain amount of deposits in banks for the purpose of boosting public confidence in

banks. Cross-border insolvency law as an ex post scheme deals with the insolvency of

internationally active banks and financial institutions without posing systematic risk

on the real economy.

4.1. Bailout

Bailout is a kind of ex post government intervention and expenditure for

assisting a financial enterprises to overcome financial distress when it is incapable of

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meeting its financial obligation. Therefore, it can prevent failure in the near future.

(Block, 1992) It aims to save the entities or industry from collapse. It prevents

bankruptcy of the enterprise which otherwise has systematic effect on the economy

and the society at large. Bailout protects employees from unemployment and

depositors during financial crises. They can all benefit directly or indirectly from the

bailout. (Block, 1992)

However, it raises another issue of moral hazard. Since the failure is

compensated financially, the incentive to avoid crisis from happening will be reduced.

It also makes the existence of ex ante preventive regulatory measures absurd, unless

there is a harmony between them, through an international context, it would be very

difficult to have both regulation and compensation schemes in tune. Therefore, a

general government intervention to bail out the problematic institutions would

encourage higher risk taking, which might create even larger losses.

A special bailout policy is necessary to balance the advantage of the bailout

with a careful consideration of the consequence. It should be developed when there is

absence of crisis. Guideline should be established for how the bailout policy is to be

conducted in maximizing the public interest. For instance, in what kind of situation,

appropriate time and other factors. (Block, 1992) On the other hand, critics argue that

government bailout was the most important cause of the crisis in 2008. (Miron, 2009)

The subsequent enactment of the Emergency Economic Stabilization Act of 2008 by

the United States (‘U.S.’) government aims primarily at bailing out the U.S. troubled

financial institutions. Such response has been criticized as an inappropriate use of

taxpayer money and such bailout was not successful in preventing the contagious

effect to the whole world. (Watson, 2011) Many countries seriously suffered due to

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the collapse of the U.S. financial market. Therefore, bailout was not the best solution

in resolving the crises. The Hong Kong government intends to avoid the need to

bailout troubled financial institutions. Instead, it is proposing a special resolution

regime, which will be discussed in the latter part of the paper.

4.2. Deposit insurance

Deposit insurance is a kind of financial safety net for depositors. Deposit insurance

aims at reinforcing the public confidence and minimizes the possibility of bank runs

in order to maintain the bank stability. (Kam, 2011) However, recent empirical results

show that the deposit insurance has a stabilizing effect only in the short run. The

effect will deteriorate over time and it makes no difference whether the deposit

insurance is present or not in relation to the likelihood of the occurrence of banking

crises. (Kam, 2011) This is due to the problem of moral hazard resulting from full

coverage of the insured deposit.

The coverage limit affects the effectiveness of the scheme. If the coverage

limit is low, the scheme does not work effectively to prevent bank runs. If the

coverage limit is high or full, the depositors will have low incentive to monitor banks

while banks have high incentive to take excessive risk in investment since the

deposits are guaranteed. They contribute to moral hazard. Therefore, higher deposit

insurance coverage will intensify the moral hazard problem which engenders banking

crises in the long run. (Kam, 2011) For instance, the full deposit insurance scheme in

Turkey introduced in 1996, encouraged banks to behave riskier, which resulted in a

banking crisis in 2001. (Onder and Ozyildirim, 2008)

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During the 2008 financial crisis, most of the countries raised their coverage or

full deposit guarantee as a temporary measure against the financial turbulence. (Onder

and Ozyildirim, 2008) Hong Kong also adopted the same measure in 2008-2010. The

Hong Kong Deposit Protection Scheme (‘HKDPS’) was introduced in 2006. In

September 2008, there was a bank run related to the Bank of East Asia. The HKMA

instructed the HKDPS to offer full deposit insurance coverage as a temporary measure

until the end of 2010. As a result, the bank run in 2008 was saved by the

announcement of full deposit guarantee by the HKDPS. (Onder and Ozyildirim, 2008)

Subsequently, the coverage was raised from originally HK$ 100,000 to HK$500,000

from the beginning of 2011. (Onder and Ozyildirim, 2008) Therefore, in order to build

up market discipline, the coverage limits should be established in covering the vast

majority of small depositors, while the large depositors have incentive to monitor the

bank activities. (Onder and Ozyildirim, 2008)

However, this measure cannot guarantee that it always works in preventing

banking crises. An effective ex post compensation scheme cannot be achieved without

a sufficient liquidation regime for insolvent banks.

4.3. Insolvency Laws

A special resolution regime for banks is important in the long run, especially

in the place which has experienced bank failure. It includes cross-border bank

insolvency, deposit insurer’s extensive power to bank resolution and adoption of Key

Attributes of Effective Resolution Regimes for Financial Institutions (‘Key

Attributes’). They are going to be further discussed after introducing the failure of

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internationally active banks in Hong Kong.

4.3.1. Experience of bank failure in Hong Kong

The experiences of the bankruptcies of Bank of Credit and Commerce Hong

Kong (‘BCCHK’) and Lehman Brothers entities in Hong Kong have shown that

public confidence in banks has been diminished. It also reflects that the deposit

insurance scheme in Hong Kong does not always work properly against banking

crises. As a result, public confidence cannot be effectively maintained under the

present compensation scheme. Hence, a special resolution regime for banks is

necessary to liquidate the troubled banks in consideration of the public interest. Bank

is a special institution which should be differentiated from normal corporation as they

have significant impact on the socio-economic development of a society. (Hüpkes,

2005)

However, the liquidation proceedings of Hong Kong banks, either local or

foreign subsidiaries, are in line with those of ordinary companies. (Lastra, 2003) They

are both under the same rule stipulated in the Companies (Winding Up and

Miscellaneous Provisions) Ordinance [2] and Bankruptcy Ordinance [3]. Moreover, in

consideration of a gradually high interconnected and interdependence of banking

systems in the world, Hong Kong legislation should raise the awareness of the

importance of international cooperation by adopting a proper cross-border bank

insolvency regime.

4.3.2. International Cooperation and Coordination in cross-border bank

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insolvency

International cooperation and coordination for cross-border bank resolution is

particularly crucial in Hong Kong as most of the banks are foreign-owned, and some

of whom are from the consolidated groups of systematically important financial

institutions. Dr. Lastra considered principles developed by the Basel Committee on

Banking Supervision in relation to the cross-border supervision of branches and

subsidiaries and found out that they could be applied insolvency of cross-border banks.

According to the Basel Committee, there are two fundamental principles: firstly, no

foreign banking establishment should escape supervision; and secondly, the

supervision should be adequate. Therefore, the host state supervisors are responsible

for the branches and subsidiaries of foreign banks operating in Hong Kong while the

parent supervisors are responsible for the banking groups. Parent supervisors and host

supervisors should inform each other in case of any serious problems arising in the

subsidiaries or the parent bank. This kind of mutual co-operation between supervisory

authorities should be analysed to apply in cross-border bank insolvency. (Lastra, 2003)

At the present stage, Hong Kong does not have international cooperation on

cross-border bank resolutions. The FSB reviews show that legal framework on this

issue is less well developed in most FSB jurisdictions. Progress has been made

gradually. The resolution authorities in Singapore and Switzerland support and give

effect to resolution actions taken by foreign resolution authorities. In the EU, the

recent Recovery and Resolution Directive requires the member states participating in

the Single Supervisory mechanism to make provisions for their domestic resolution

regimes to support and recognize the actions of the resolution authorities in other

countries. They might be mandated to consider the impact of their resolution actions

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on financial stability in other member states. (Financial Services and the Treasury

Bureau et al., 2014)

International cooperation and coordination on cross-border bank resolution is

a complicated issue. It requires a sophisticated legal framework and sufficient

information sharing in order to facilitate an appropriate way in resolving troubled

banks with less impact on financial stability.

4.3.3. Extensive Power of Bank Resolution to Deposit Insurer

Extending the power of the deposit insurer for bank resolution is also another

good way to deal with insolvent and troubled banks in consideration of the public

interest. However, the Hong Kong Deposit Protection Scheme (‘HKDPS’) does not

adopt this power. The mandates for the HKDPS has been stated clearly in the Deposit

Protection Scheme Ordinance [4] that Deposit Protection Scheme should generally

function as a ‘paybox’ type system which mainly focuses on paying out depositors

claims when a bank fails. Due to its mandate, the Scheme has little role in early

detection and resolution of troubled banks. The Board of the Scheme works closely

with the HKMA to ensure that compensation payments to depositors are done in an

expeditious manner. (Hong Kong Deposit Protection Board, 2009)

With the increasing amount of international banking activities in Hong Kong,

in particular after the collapse of Lehman Brothers in 2008, it is a suitable time for

Hong Kong to conduct legislative reform preventing future banking crises. Hong

Kong should seek ways of enhancing the mechanisms in dealing with failing or failed

banks. Since a deposit insurer will have a major impact on how the failed banks are

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resolved, (International Association of Deposit Insurers, 2005) the HKDPS should

play a role in the resolution of failed banks by taking depositors as the priority

concern. Besides acting as a guarantor for the public deposits, the HKDPS should be

more independent, that is, insulated from undue political and industrial influence.

(International Association of Deposit Insurers, 2005)

The International Association of Deposit Insurance (‘IADI’) provides

guidance on enhancing the mechanism for the resolution of failed banks. The power

of the deposit insurer is not only to pay out the deposits to the depositors in a timely

and orderly way, but also to intervene early for inspection of troubled banks and to

conduct resolution of failed banks with an appropriate approach. It also promotes a

good check and balance system with other regulators. Good coordination between

local regulators and foreign authorities is necessary if it is to ensure cross-border bank

insolvency. (International Association of Deposit Insurers, 2005)

In the U.S., the Federal Deposit Insurance Corporation (‘FDIC’) has been

given power to address the problems of large and complex financial institutions which

can pose systemic risk. (Federal Deposit Insurance Corporation and the Bank of

England, 2012) This power comes from the Dodd-Frank Wall Street Reform and

Consumer Protection Act of 2010 (‘Dodd-Frank Act’) which greatly increases the

ability of regulators to address the problems and to exercise resolution powers on

systematically important financial institutions. Such strategy is designed to assign

losses to shareholders and unsecured creditors of the holding company, and transfer

sound operating subsidiaries to new solvent entities. Title I of the Dodd-Frank Act

requires each large and complex financial institution to submit a resolution plan which

accords to the U.S. Bankruptcy Code to the FDIC and the U.S. Federal Reserve. The

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plan is reviewed and examined. The approved plan will facilitate the exercising of the

FDIC’s resolution power to undertake an orderly resolution under bankruptcy in the

event of failure. (Federal Deposit Insurance Corporation and the Bank of England,

2012)

Bank resolution power is delegated to the FDIC under Title II of the Dodd-

Frank Act [5] to liquidate the financial institutions which might pose systemic risk

and cause financial instability. No loss of the failed financial institutions should be

borne by taxpayers, but the senior management and shareholders should bear such a

loss. The FDIC is required to carry out the resolution that is to minimize the risk of

financial stability and moral hazard. Any costs in resolving the financial institutions

will be recovered by the industry.

This approach can avoid conflict of interest where the regulator has both

financial supervision and crisis resolution powers. In Korea, the Financial Supervisory

Commission (‘FSC’) is endowed with both responsibilities of supervision and

resolution on financial institutions. It experienced serious conflict of interest during

the bank restructuring in the 1997 financial crisis. (Kawai et al., 2012) Therefore, this

mechanism can be effectively applied if the deposit insurer is an independent agency.

However, HKDPS has to perform functions subject to the decision made by the

HKMA. If Hong Kong has to adopt this approach, the structural reform has to be

conducted in the HKDPS.

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4.3.4. Key Attributes of Effective Resolution Regimes for Financial Institutions

(‘Key Attributes’)

Key Attributes is a guideline set up by the FSB in November 2011. (Financial

Stability Board, 2011) It provides a framework for implementation of an effective

resolution regime of all jurisdictions for any financial institution which is systemically

significant. (Financial Stability Board, 2012) It allows authorities to resolve the

financial institutions in an orderly manner. The power also includes the ability to

override the rights of shareholders, to replace management which is responsible for

the loss. It can also transfer the critical functions of a failing firm to a bridge firm,

where the critical and main function of the firm keeps operating. Thus, it can

minimize the negative impact on economy and society. Such transition also suits the

cross-border nature of the financial institution whose subsidiaries in foreign countries

are still working under its control to minimize the global systemic risk. (Federal

Deposit Insurance Corporation and the Bank of England, 2012) By converting the

unsecured debt into equity from senior creditors of a failed company, a failing

financial firm will be recapitalized and thus the bailed-in creditors will become the

owners of the resolved firm. As a result, such approach can maintain financial

stability without cost to taxpayers. (Permanent Bureau, 2013)

In addition, the Key Attributes also puts emphasis on the coordination of the

cross-border resolution authorities with the consideration of the impact of their

resolution actions on the financial stability of foreign jurisdictions. It helps to ensure

the local resolution authorities support the resolution conducted by a foreign authority.

Therefore, a close cooperation between local and foreign authorities is crucial.

(Permanent Bureau, 2013)

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4.3.4.1. Difficulties in the Implementation of Key Attributes

According to the peer review on resolution regimes published by the FSB on

11 April 2013, some FSB jurisdictions have implemented the Key Attributes in their

reforms of resolution regimes. The problem they have encountered is that the

resolution authorities lack important powers, such as the power to bail in, when

resolving difficulties within systematic institutions. In addition, they also lack the

power to control the parent company and its subsidiaries of a failed financial

institution, and the power to resolve systematic non-bank institutions, for instance,

financial market infrastructure providers. There are also insufficient procedures for

giving effect to foreign resolution actions or for domestic authorities to share

confidential information. Furthermore, there is a lack of power in demanding firms to

make changes on their organizational and financial structures in order to facilitate the

process of insolvency. (Financial Stability Board, 2013)

4.3.5. Hong Kong situation

Arner (2010) points out that Hong Kong still lacks a crisis management

scheme for banks, and it also highlights the weakness of the deposit insurance scheme

in dealing with failure of financial institutions. Hong Kong has not adopted the bank

resolution regime -- Key Attributes proposed by the FSB nor is any resolution power

given to deposit insurer under the HKDPS to early intervene in the bank resolution

and carry out resolution. Moreover, there is inadequacy of the existing powers of the

regulators to carry out resolution of the financial institutions (Financial Services and

the Treasury Bureau et al., 2014); they can only process their insolvency under

corporate insolvency proceedings. Hong Kong regulators, the HKMA and the SFC

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have the power to appoint a special manager to take over the affairs and business of a

failing company in the commencement of administrative proceedings. [6]

Compared to the international standard of resolution regimes, Hong Kong has

not yet met any of them, despite the fact that it is an international financial centre

which has thousands of banks dealing with millions of banking activities every day. In

response to this deficiency, Hong Kong, as a member of the FSB, has begun to make a

move in satisfying the standards of the Key Attributes set by the FSB. Starting from 7

January 2014, the Financial Services and Treasury Bureau of the government of Hong

Kong Special Administrative Region, in conjunction with the HKMA, the SFC and

the Insurance Authority (‘IA’) has initiated public consultations on establishing an

effective resolution regimes for financial institutions, followed by the outcome of the

draft resolution regime bill to be submitted to the Hong Kong’s Legislative Council in

2015. (Hong Kong Monetary Authority, 2014) It is important to note that it is

necessary to ensure efficient cross-border coordination amongst bank regulators as the

banks operating in Hong Kong are mainly foreign-owned, which are usually the

subsidiaries or branches of systematically important financial institutions. Thus, as a

host city the Hong Kong’s resolution regime should reflect development in markets of

parent countries. (Bauer, 2014)

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5. Coordination between ex ante measures and ex post

schemes

Excessive and inappropriate use of the compensation measures, i.e. bailout and

deposit insurance, creates moral hazard which can consequently encourage the

violation of preventive regulatory measures. Since the financial failure is

compensated for by the public or the government, it makes the existence of ex ante

regulatory measures absurd. Unless there is a harmonious coordination between them,

through an international arrangement, it would be very difficult to have both

regulation and compensation schemes in tune.

Soon after the 2008 financial crisis, when the EU was undergoing reforms of

bank crisis resolution, Giani (2010) pointed out the requirement of complementarities

between financial supervision and crisis resolution for safeguarding financial stability.

Alexander (2013) expressed that effective prudential regulation and supervision

requires a seamless process in adopting ex ante prevention measures and ex post

resolution powers. The EU recognises this important link and thus financial reform

creates a banking union [7] in fostering such link through the single supervisory

mechanism and single resolution mechanism. Therefore, it facilitates the

harmonization between ex ante and ex post measures in order to stabilize the

European financial system.

In the developing countries or emerging markets, the issue of coordination

between preventative regulatory measures and compensation schemes is exacerbated

where the legal and regulatory institutions are weaker and less coordinated compared

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to well-developed markets such as the UK or even HK markets. This is on top of

some other challenges in such markets. It is argued that emerging markets often lack

well-developed and well-structured bankruptcy regimes. (Frankel 1998) This could

result in the increased likelihood of bankruptcy and reduce the chance of recovery. In

such an environment the likelihood of coordination between regulatory laws and

bankruptcy laws is also very low and coordination between these legal regimes could

not be achieved.

These are complex conceptual and practical challenges that emerging market

economies face in the aftermath of the global financial crisis. These challenges are not

unique to emerging markets but are heightened by the capacity and institutional

constraints in these economies. Reddy et al. (2013, 2014) highlights that the linkage

between ex post and ex ante aspects of markets particularly in respect of rules on

mergers and acquisition in the emerging markets, such as India, which are also deeply

integrated into global financial markets. Emerging markets need to balance the quest

for financial stability with the imperatives of financial development and broader

financial inclusion. Prasad (2010) has argued that these objectives can actually

reinforce one another. It has also discussed aspects of macroeconomic policies that

have implications for financial stability and the resilience of the financial sector in

emerging markets.

Nevertheless, practically, giving supervision and resolution powers to the

same regulator can create conflict of interests, as could be seen in the Korean

experience during the 1997 financial crisis. The FSC in Korea had to forbear on banks

that could not meet the regulatory requirements due to problems caused by the

resolution actions in the crisis period. It undermined the effectiveness of supervision

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on the financial institutions. (Kawai et al., 2012) Besides the emphasis of such

importance in proposing any ex ante and ex post measures against financial crises, it

is crucial and worth further raising the awareness of the cooperation and coordination

between host and home countries for cross-border bank resolution. It minimizes the

contagious and disastrous effect to the global financial stability.

6. Conclusion

In conclusion, understanding the fact that regulatory response towards the recent

global financial crisis is national and insufficient; more effort has to be put on

international cooperation with other international organizations to conduct regulatory

reforms in line with international standards, for instance, the FSB. Peer pressure is

beneficial in resolving the financial crises collectively on the basis of mutual benefits

they can get from each other, either in the form of private return or building up good

international relationships.

International coordination can facilitate the harmonious relationship between ex ante

and ex post measures. For ex ante measures, coordination should be strengthened

among regulators and foreign regulators by imposing statutory duties. For ex post

measures, a special resolution regime for cross-border bank insolvency should be

considered, in particular for places where foreign-owned banks mainly operate. Hong

Kong has begun the process of the implementation of the Key Attributes set up by the

FSB. Giving extensive resolution power to the deposit insurer is one of the alternative

suggestions, as deposit insurer can always take the interest of the depositors as their

priority concern in resolving the troubled banks.

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By obtaining a comprehensive compensation system, it is proposed that, if a good

regime of bank resolution is implemented, the idea of ‘too big, too complex or too

interconnected to fail’ might be abolished. Such a practice is beneficial to the health of

the banking system, and promotes efficiency of the market and market discipline. This

paper suggests that the harmonious coordination between ex ante regulation and ex

post compensation schemes has to be achieved through international cooperation in

order to avoid the absurd situations which might cause moral hazard. Therefore it can

maximize the effectiveness of the regulatory measures and comprehensive schemes

against banking crises.

The findings and analyses of this paper would warrant the following

recommendations and suggestions for both the banks as regulatees and regulators

alike. To achieve an ideal regulatory paradigm in which the risk of bank failure is

minimized, the following measures are recommended:

• Further coordination between banks and regulators which would lead to a

dialectical regulatory regime.

• Working out a framework within which the preventive regulatory measures are

balanced against the ex post compensation schemes, leading to the emergence

of the optimal harmonization between the two initiatives.

• Looking at all ranges of initiatives as a web of legal and non-legal actions in

various phases of “normal activity”, “failure”, “rescue” and “recovery”.

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• Understanding the international dimension of the financial markets and

working towards better coordination between the national authorities in charge

of both regulatory measures and compensation schemes.

• Practitioners should be also be recommended to take into account this

complex web which is stretched across a time span, in both drafting legal

frameworks as well as in any possible litigation related to banks.

• Home supervisors should have incentives for evaluating the state of

institutional arrangements, such as its subsidiaries or branches in emerging

market countries when considering whether and how to negotiate on

international prudential and financial liberalization issues, what interests

would be served by addressing these institutional failings. (Frankel 1998)

• Regulatory reforms suggested that would strike the balance between seeking

to avoid insolvency and lowering the costs of insolvency should it occur. For

instance, whether a lex specialis for dealing with troubled banks by prompt

corrective action and whether resolving them is necessary if their net worth

falls to zero, at little or no cost to the taxpayer can be applied in emerging

markets. (Mayes, 2005)

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Notes

[1] Securities and Future Ordinance, Cap. 571

[2] Companies (Winding Up and Miscellaneous Provisions) Ordinance, Cap 32

[3] Bankruptcy Ordinance, Cap 6

[4] Deposit Protection Scheme Ordinance, Cap. 581

[5] Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010

[6] Banking Ordinance, Cap 155, S52(1)(C)

[7] European Commission has proposed four steps in forming a banking union which

comprises single supervisory mechanism, single rulebook, common deposit insurance

and single resolution mechanism, to ensure financial stability and to minimize the

damages to the real economy when banks fail to operate. The union currently includes

6000 banks located in the 18 Member States within the European Union (‘EU’).

(European Commission, 2013)

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Minnesota Law Review, Vol. 95, pp. 1525-1531

Acknowledgement

The authors thank the Special Issue Editors and anonymous reviewers for providing notes

that significantly improved the manuscript in all stages of the peer review process. The

authors declare that they have no conflict of interest with regard to the text and material

used in this paper. The usual disclaimer applies.

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About the Authors

Eva Ka Yee, Kan is a Juris-Doctor in Chinese University of Hong Kong. She obtained Master of Laws in

International Corporate Governance, Financial Regulation and Economic Law, Institute of Advanced Legal

Studies, School of Advanced Study, University of London. She has working experience in Hong Kong Monetary

Authority as a legal research intern. Eva Ka Yee, Kan can be contacted at: evakan@cuhk.edu.hk

Dr. Mahmood Bagheri is currently a Senior Research Fellow and LLM course director in Institute of Advanced

Legal Studies, School of Advanced Study, University of London. He is also Associate Professor of Banking and

Financial Law, University of Tehran. Dr. Mahmood Bagheri can be contacted at Mahmood.Bagheri@sas.ac.uk

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