LC Paper No. CB(1)473/03-04(03) For information on 6 December 2003 LegCo Panel on Financial Affairs Examination of the regulatory work in respect of authorised institutions in the light of the “Report of the Special Committee on the Corporate Governance, Credit Approval Process, Risk Management and Internal Control Mechanism of Bank of China (Hong Kong) Limited” Introduction 1. This paper aims to explain: (i) the HKMA’s approach to the supervision of authorized institutions in Hong Kong; and (ii) the HKMA’s supervisory response following the replacement of Mr Liu Jinbao as the Chief Executive of Bank of China (Hong Kong) Limited (BOCHK). The supervisory approach of HKMA 2. The HKMA adopts a risk-based supervisory approach in its supervision of authorized institutions (AIs) in Hong Kong. The approach involves a systematic risk assessment process to understand the business and identify the risks facing individual institutions and to assess the adequacy and effectiveness of their control systems. The results of this assessment process will be used to devise an appropriate programme to be applied to the institution concerned. Under this approach, the intensity of supervision and the amount and focus of supervisory action will increase or decrease in line with the perceived risk profile of the institution. In other words, the HKMA will devote more supervisory resources and attention to an AI if it considers that 1 the level of risk associated with that institution is high after taking into account its business and risk control systems. 3. The supervisory approach of the HKMA is based on a policy of “continuous supervision” through a combination of on-site examinations, off-site reviews, prudential meetings with the management and tripartite meetings with the institution and its external auditors. The aim is try to establish that policies, procedures, and internal controls of an institution are effective and adequate to ensure that prudent business practices are followed and its risks are properly managed. 4. If the HKMA identifies problems or deficiencies in the systems, procedures and controls of an institution in the course of its supervisory process, the HKMA will require an action plan for implementing appropriate corrective actions. The HKMA monitors the implementation of the action plan as part of its ongoing supervision of the institution. 5. Notwithstanding the supervisory role of the HKMA, it remains the responsibility of the management of an AI to ensure that its business is conducted with integrity, prudence and competence. AIs are also expected to have in place a comprehensive risk management system to manage its risks. The HKMA has issued various guidelines and guidance notes to the industry, which represent either minimum standards or in some cases best practices to be adopted by AIs. AIs are expected to have systems and procedures in place to ensure compliance with these guidelines and guidance notes as appropriate. Supervisory response after the replacement of Mr Liu Jinbao as the Chief Executive of BOCHK 6. Following the sudden replacement of Mr Liu Jinbao as the Chief Executive of BOCHK in late May 2003 and the revelation that his removal might be related to a loan made to New Nongkai Global Investment Ltd. (New Nongkai) which was under the control of Mr Chau Ching-ngai, the HKMA sent in a team to conduct a review of the loan in question. 2 7. In order to have a more thorough and independent view on the scale and scope of the problem, the HKMA pursuant to section 59(2) of the Banking Ordinance required BOCHK to appoint two external auditors approved by HKMA to review and report on (i) BOCHK’s exposures to Mr Chau and his affiliates (the Chau group ) - by Moores Rowland and, (ii) on high level controls, credit approval processes, credit risk management, internal control mechanism and asset quality - by KPMG. 8. At the same time, the board of BOCHK decided to set up a Special Committee comprising Mr Anthony Neoh, the Special Advisor to the Board and Mr Victor Fung and Mr Weijian Shan, both independent non-executive directors, to review, among other things, the credit approval, credit risk management and related internal control mechanisms for corporate lending of the bank. 9. Apart from these reviews, the board also commissioned a full audit of the bank’s interim results for the first half of 2003. 10. From the beginning, the HKMA encouraged the bank to be as transparent as possible. Public statements concerning the loan to New Nongkai, the setting up of a Special Committee for credit review, the commissioning of a full interim audit and section 59(2) reviews, and the Report of the Special Committee were put out by the bank on 6 June, 10 June, 17 June and 5 September, respectively. 11. Apart from reviewing the position of BOCHK through the means described above, the HKMA conducted specialised examinations on 10 AIs during June and July 2003. The aim of these examinations was to establish that prudent lending policies, practices and procedures were being followed by the institutions concerned. The institutions were selected for examination based on an internal assessment of their risks and business operations. As with other examinations conducted by the HKMA, areas for improvement, none of which was considered serious, were noted, and remedial actions were required to be undertaken by the institutions concerned. 3 Findings of the Special Committee’s Report and the section 59 reports 12. On 5 September, the board of BOCHK released the full Special Committee’s Report with the major findings of the two section 59(2) reports (copy attached), along with its interim results for the six months ending 30 June 2003. 13. The reports prepared by the Special Committee and the auditors under section 59(2) of the Ordinance have made a number of recommendations to improve and enhance BOCHK’s management capability, credit approval procedures, risk management function as well as high level controls. Conclusion 14. The board of BOCHK has voluntarily disclosed the full Special Committee report and the major findings of the s59 reports. The key issues identified in the reports are being addressed by the bank. The credit loss, if any, arising from the loan to New Nongkai will not threaten the viability of BOCHK. The HKMA is monitoring the bank’s implementation of the recommendations made in the various reports. 15. All AIs in Hong Kong are subject to the same supervisory standards and regulatory requirements. The supervisory response of the HKMA in this case as mentioned above is in line with the HKMA’s usual practice. Hong Kong Monetary Authority December 2003 D:\FA Panel\Paper 6 Dec - BoC.doc 4 關於中國銀行（香港） 有限公司 公司治理、授信審批程序、 風險管理及內部監控機制的 專責委員會調查報告 Report of the Special Committee on the Corporate Governance, Credit Approval Process, Risk Management and Internal Control Mechanisms of Bank of China (Hong Kong) Limited 二○○三年九月 September 2003 Table of Contents Pages Summary of Findings and Recommendations 2-6 Paragraphs I. Introduction 1-3 II. The New Nongkai Loan The current state of the loan 4-6 Errors of judgment 7 The lessons learnt 8-11 Who was responsible 12-22 Actions already taken or to be immediately taken 23-26 III. Stronger Foundations for Higher Standards Continuing integrity of credit and risk management process 27-32 Enhancing management structure 33-37 Recommendations to enhance corporate governance 38-44 Conclusion: reaching for higher standards 45-48 Appendices: Pages 1. Terms of reference of the Special Committee 20 2. Abbreviations and definitions 21 3. Summary of the findings of Moores Rowland 22-23 4. Summary of the findings of KPMG 24-29 5. List of staff and external parties interviewed 30 1 Summary of Findings and Recommendations The Committee submits the following findings and recommendations to the Board, through the Audit Committee: (i) The Current State of the New Nongkai Loan (“the loan”) • The bridging loan was HK$1.77 billion (which was the final amount drawn from a facility of HK$2.107 billion), of which HK$1.03 billion has been repaid, leaving HK$740 million outstanding as at 30 June 2003; • As collateral for the outstanding loan, the Bank has a first legal charge over 75% of the shares of Shanghai Land; • Receivers have been appointed to Shanghai Land, and there is HK$1.2 billion in a deposit in the name of the Receivers with the Bank. It is understood that the company has minor liabilities which could be applied against this deposit; • The Special Committee is satisfied that active steps are being taken for recovery. The loan was assessed by Moores Rowland as part of their Section 59 Review. They recommended that, as at 31 May 2003, a loan classification of “special mention” and, consistent with that, made no recommendation for a specific provision. However, the loan is currently classified by the Bank as “substandard”, and a specific provision of HK$126 million has been made. PwC has concurred with this level of specific provision, included in the audited accounts for the six months ended 30 June 2003. (ii) Errors of Judgment • The loan was granted according to the procedures and delegated authorities then applicable. Though large, it was not a loan which required Board approval, and therefore would not have come to the Board’s attention until circumstances so required e.g. were it to become non-performing; • As far as we could determine, the procedures were followed, but in our opinion the judgments surrounding the making of the loan were faulty: — Although the risks were identified at the start, they were not adequately addressed in the following respects: ➢ The Bank never obtained sufficient information on Mr.