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: [email protected]
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 [email protected]
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