Asian Financial Markets

ISSN 1358-1988 Volume 17 Number 1 2009 Journal of Financial Regulation and Compliance Asian financial markets Guest E...

Author: Journal of Financial Regulation and Compliance | Keasey | Kevin.; Cai | Charlie

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ISSN 1358-1988

Volume 17 Number 1 2009

Journal of

Financial Regulation and Compliance Asian financial markets Guest Editors: Kevin Keasey and Charlie Cai

www.emeraldinsight.com

Journal of Financial Regulation and Compliance

ISSN 1358-1988 Volume 17 Number 1 2009

Asian financial markets Guest Editors Kevin Keasey and Charlie Cai

Access this journal online __________________________

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Editorial advisory board ___________________________

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Guest editorial ____________________________________

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CONTENTS

Chinese investment goes global: the China Investment Corporation Charlie Cai and Iain Clacher ______________________________________

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Japan: the banks are back! Or are they? Maximilian J.B. Hall _____________________________________________

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Multinational banking in China after WTO accession: a survey Chen Meng ____________________________________________________

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An overview and assessment of the reform of the non-tradable shares of Chinese state-owned enterprise A-share issuers Paul B. McGuinness _____________________________________________

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This journal is a member of and subscribes to the principles of the Committee on Publication Ethics

CONTENTS continued

Market risk disclosure: evidence from Malaysian listed firms Radiah Othman and Rashid Ameer_________________________________

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LEGAL COMMENTARY Extent to which financial services compensation scheme can pursue claims assigned to it by investors whom it has compensated Joanna Gray ___________________________________________________

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Court of Appeal dismisses appeal on admissibility of FSA material as evidence in Directors Disqualification Proceedings Joanna Gray ___________________________________________________

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JFRC 17,1

EDITORIAL ADVISORY BOARD Professor Mads Andenas Department of Law, University of Leicester, UK Paul Arlman Former Secretary General of Federation of European Stock Exchanges, The Hague, The Netherlands

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Professor Mukul G. Asher Lee Kuan Yew School of Public Policy, National University of Singapore, Singapore

Professor David T. Llewellyn Department of Banking, Financial Markets and Institutions, Loughborough University, UK Professor Eva Lomnicka School of Law, King’s College, University of London, UK Dr Oonagh McDonald Visiting Fellow at the International Institute of Banking and Financial Services

Dr John Ashton School of Management, University of East Anglia, UK

Professor Paul B. McGuinness Chairman of Department of Finance, Chinese University of Hong Kong, Hong Kong

Graham Bishop Director of Grahambishop.com, East Sussex, UK

Walter Merricks Chief Ombudsman, Financial Ombudsman Service, UK

Professor Dr David Bland OBE Former Director General of the Chartered Insurance Institute, London, UK

Professor Paolo Mottura Professor of Financial Markets and Institutions, Universita Luigi Bocconi, Italy

Professor Arnaud W.A. Boot Faculty of Economics and Econometrics, Finance Group, University of Amsterdam, The Netherlands

Professor Andy Mullineux Professor of Global Finance, Birmingham Business School, University of Birmingham, UK

Richard Burger Solicitor, Reynolds Porter Chamberlain LLP, London

Dr Chizu Nakajima Director of the Centre for Financial Regulation, Cass Business School, City University, UK

Andrew Campbell Reader in International Business Law, University of Leeds, UK Professor Riccardo De Lisa University of Cagliari, Italy Jos de Wit Advisory Board Member, Association of Certified AntiMoney Laundering Specialists, The Netherlands Professor Joshua Doriye Principal of the Institute of Finance Management, Dar Es Salaam, Tanzania Professor Robert Faff Department of Accounting and Finance, Faculty of Business and Economics, Monash University, Australia Michael Foot CBE Chairman Promontory Financial Group (UK) Ltd, London, UK Professor Charles Goodhart Programme Director of Regulation and Financial Stability, Emeritus Professor of Banking & Finance, London School of Economics, UK Professor Max Hall Department of Banking, Financial Markets and Institutions, Loughborough University, UK Professor Jenny Hamilton University of Strathclyde Law School, UK Professor David Hillier Department of Accounting and Finance, Leeds University Business School, The University of Leeds, UK Professor Allan Hodgson Amsterdam Business School, Universiteit van Amsterdam, The Netherlands Dr Robert Hudson Department of Accounting and Finance, Leeds University Business School, The University of Leeds, UK

Journal of Financial Regulation and Compliance Jonathan Levin Vol. 17 No. 1, 2009 Partner, Reed Smith LLP, USA p. 4 # Emerald Group Publishing Limited 1358-1988

Professor Michael Ong Director of Finance Programme, Stuart Graduate School of Business, Illinois Institute of Technology and Former Executive Vice President and Chief Risk Officer, Cre´dit Agricole Indosuez, New York, USA Professor Julio Pindado Dept. Administracion y Economia de la Empresa, Universidad de Salamanca, Spain Professor Barry A.K. Rider Fellow of Jesus College, Cambridge University, UK and Executive Director of the Centre for International Documentation on Organised and Economic Crime Joe Rosenbaum Partner, Reed Smith LLP, USA Dr Dalvinder Singh Associate Professor of Law, University of Warwick, UK David Thomas Principal Ombudsman for Banking, Financial Ombudsman Service, UK Professor Robert Watson Department of Economics and Finance, Durham Business School, Durham University, UK Nick Weinreb Group Head of Regulation, EuronextLiffe, London, UK Professor James Wilcox Knuttschnitt Family Professor of Financial Institutions, Hass School of Business, University of California, Berkeley, USA Dr Michael Wolgast Chief Economist and Head of Economics Department, German Insurance Association, Berlin, Germany Professor Mike Wright Centre for Management Buy-Out Research, Nottingham University Business School, UK Dr Zhishu Yang School of Economics and Management, Tsinghua University, Beijing, PR China

Guest editorial The editorial for this issue of JFRC comes at a very interesting time and is split into two parts. The first part examines the credit crunch and considers the impact on regulation and compliance. The second part introduces this special issue on Asian Financial Markets.

Guest editorial

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The credit crunch – more to come! In January 2003, I wrote an article titled “Bah humbug” (University of Leeds, IIBFS Focus Report) which highlighted my concerns with the growing debt burden in the UK. I concluded the article with the following question: The question is will our new borrowing habits bring the whole economy down or just the unlucky few?

We, of course, now know the answer – the “age of financial irresponsibility” has almost brought the whole system down and it will have a lasting and painful legacy. The basic cause of the crisis has been the uncontrolled provision of debt on the back of a “wall of cash” from the Far East. Money has been provided in such quantities that individuals, companies and countries have eventually struggled to meet repayments – this issue was heightened when money markets froze but we should not forget that any entity has a sustainable level of debt and these were exceeded a long time ago. The debt overhang problem has been exacerbated at the system level because debt has been repackaged to such a degree that nobody knows who is bearing what and thus the fundamental plank of the financial system, trust, has been removed and will take a long time to recover. The $55 trillion credit default swap market, which few people understand or know where the risks truly lie, is just one example of the financial insanity we are now facing. To get a handle on the consequences of the crisis, let me look at the major players – individuals, companies, banks, and governments. Individuals They have borrowed to buy over priced properties, holiday homes, cars, flat screen TVs, etc. They have lived the “dream” on borrowed funds. House prices are now declining, borrowing is more expensive and difficult to access, living costs have risen significantly and not surprisingly, spending is being reined in! And this is all before the significant rises in unemployment that will occur in 2009 and 2010. In short, many will have to significantly tighten their belts and for some this is going to be a very painful adjustment process. One imponderable is how far this financial stress will feed through to pay demands given the increases in unemployment. Companies We have already seen significant distress in the property, construction, car and retail sectors but this is just the start of the mounting pressures. All indicators point to a significant tightening of the corporate sector, with increased numbers of insolvencies and redundancies. Many companies have been postponing their cutbacks, hoping for

Journal of Financial Regulation and Compliance Vol. 17 No. 1, 2009 pp. 5-8 q Emerald Group Publishing Limited 1358-1988

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glimmers of light, but it now looks likely that many will action cost reduction processes this winter. Banks and other financial service organisations Over the past couple of months, we have seen a lot of distress in the banking sectors around the world, with huge government bail-outs in many countries. Over the coming months, we will see more distress in hedge funds as they struggle to sell assets at realistic values and raise further funds. Equally, we have not seen the last of the distress in the insurance sector as the de-leveraging continues to unwind. Finally, the banks will need further capital as they are forced, quite rightly, to strengthen their balance sheets. The consequence of this is that the availability of funds will continue to be limited with an obvious impact on individuals and companies. The Government If the above are not concerning enough, we have the past, present and future actions of the government to consider. In all kinds of ways, we have ended up with a very unbalanced economy and society. First, there is the over reliance on the financial sector that has been promoted for far too long to the detriment of many across the UK. Second, there has been the burgeoning public sector which has not given us the improvements which should have been achieved given the spending. Third, we have the high taxation and borrowing levels which have paid for the ineffective spending with obvious consequences for the balance between the individual and the state, private and public. In essence, we have a very highly leveraged and unbalanced economy and society, and the nature of the response by the government will determine how long we have to pay for the mess. The appropriate response will be to have a judicious amount of government spending and tax cuts but to let the consumer and companies rebalance their activities in the face of a “normal” lending environment. Quite simply, we have to learn to live within our means and this will not be a bad thing given issues with food and the environment. More likely, however, is that the government will try to spend its way out of the crisis by further borrowing. This will have a number of serious and lasting consequences. First, the public sector may well crowd out the private sector to the long-term detriment of the UK as a global trading nation. Second, we will be merely delaying the eventual adjustment of individuals and organizations to a sustainable borrowing environment and the cost will be even higher the longer it is avoided – we will have learnt nothing from the costly Greenspan punts over the past decade. In summary, I suspect the government will borrow and spend, and we will be in the current recession until the autumn of 2010 but the actions of the government will have consequences for many decades as we all struggle to pay for the mountains of debt and an increasingly, uncompetitive and unbalanced economy/society. Given all of the above, the interesting question is what this all means for regulation and compliance? It is quite clear that there are going to be demands from government and society for better regulation and compliance, and this raises a number of issues. First, how do we organize regulation for a global economy when it is presently driven at the national level? Second, how do we regulate complex financial products when even the experts struggle to comprehend them? Third, how should we tackle “off balance” sheet entities which have been such a feature of the present crisis?

Fourth, how do track risk when the financial system is a complex web of companies, products, sectors and countries? Fifth, where do the skills and experience come from given that regulation and compliance has played such a second fiddle for so long? Finally, what role should academics play in forming the regulation and compliance agenda going forward? To my mind, we have to be a lot more vocal in our concerns and be open to different research methodologies. For example, there is little doubt that the slice and dice model of shoveling risk around the globe and complex derivative products both played their role in the present crisis and both suffer (along with a lot of academic finance) from the assumption that risk is largely exgonous to the parties directly involved – which is clearly incorrect given recent events. As an editor, I welcome explorative and agenda creating articles on regulation and compliance. Kevin Keasey Asian special issue I have had the pleasure of assembling a special issue on Asian Banking and Financial Markets. Given the rise of Far Eastern economies as significant global players and the changing landscape of global economic and financial markets, the timing of this issue could not have been better. As the world economy continues to adjust to the credit crisis, with consequences for all countries across the globe (witness manufacturing companies in China laying off thousands of workers as the rest of the world reins in its spending), understanding different aspects of the Asian financial system is ever more important. To this end, and at the request of Kevin Keasey, the first article, by Iain Clacher and myself, reviews the behavior and actions of the Sovereign Wealth Fund (SWF) – the Chinese Investment Corporation (CIC). SWFs are an increasing feature of the global financial system and their influence is likely to increase as global institutions (and countries) have to recapitalize; a good and recent example if this is Barclays turning to the Royal Family of Abu Dhabi for significant funds. The article on CIC describes the size and strength of SWFs and highlights the increasing freedoms of CIC to play a significant role on the global stage. The second and third articles are concerned with Japanese and Chinese banking markets. We all know that Japan has suffered from its own banking and financial crises for quite some time but there has been a suggestion that it is now out of the woods. Maximillian Hall’s article suggests, however, a note of caution on low levels of core profitability and asset quality. None the less, he ends on an upbeat note stating that Japanese banks are back on track. The next article by Chen Meng analyses how multinational banks have accessed China post-WTO accession. From a base of a number of interviews, Chen Meng, concludes that multinational banks need to be clear about their strategic objectives and to be aware of the efforts needed to establish networks, client resources and human assets. However, this task has become more difficult as a result of the credit crunch because regulators and market participants are both more cautious of the “western banking models.” The final two papers in this issue are concerned with the financial markets of China and Malaysia. Paul McGuinness examines the reform of the non-tradable shares of Chinese state-owned enterprises (SOEs) and shows there is little evidence of significant stock disposals by the SOEs and notes that given the recent

Guest editorial

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significant falls in the Chinese stock markets, the authorities have every incentive to dampen large-scale share sell-offs. However, as a number of share restrictions are not relaxed until 2009-2011, the full impact of the share reform in China will take some time to be evidenced. The final paper in this issue investigates the market risk disclosure practices of Malaysian listed firms. The findings indicated that Malaysian firms do not report credit risk and there is, therefore, in these difficult financial times, a need to improve risk reporting and achieve greater financial transparency. Charlie Cai

The current issue and full text archive of this journal is available at www.emeraldinsight.com/1358-1988.htm

Chinese investment goes global: the China Investment Corporation

Chinese investment goes global

Charlie Cai and Iain Clacher University of Leeds, Leeds, UK

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Abstract Purpose – The purpose of this paper is to provide a detailed overview of the China Investment Corporation (CIC) and its structure, investment activities and possible future investments. Design/methodology/approach – This paper uses a case study approach and builds up a picture of sovereign wealth globally and then focuses on the CIC and issues surrounding the fund. Findings – The key implications from the research are that Asian sovereign wealth is going to be increasingly important in global investment. The CICs investment strategy is evolving and becoming evermore sophisticated. As the fund grows this will result in increased demand for local financial services and expertise and so where representative offices are located will impact on those financial centers. Research limitations/implications – Future research should expand the scope of the analysis to include other sovereign wealth funds and try to map out a comprehensive picture of sovereign wealth around the world. Originality/value – This is one of the first papers to look at sovereign wealth and is believed to be the first paper to analyze Asian sovereign wealth and the CIC. Keywords Investment funds, International investments, Financial institutions, China, Protectionism Paper type Case study

An overview of the China Investment Corporation and global sovereign wealth The $200bn China Investment Corporation (CIC) was established in 2007 and is currently the 6th largest sovereign fund in the world by total assets. However, since its inception the fund has been controversial and the focus of much of the ongoing political debate about the nature of sovereign wealth fund investments. However, from Table I it is clear that the Abu Dhabi Investment Authority is the largest sovereign fund with total assets of $875bn. Of the top ten sovereign wealth funds, 70 per cent are from oil rich nations while the other 30 per cent are funded from non-commodity sources. Interestingly, the three funds that have large non-commodity surpluses are the Asian funds. To put Asian sovereign wealth into a wider context, it accounts for approximately 24 per cent of the total value of the top ten sovereign wealth funds. With total assets of approximately $638bn, Asian sovereign wealth is considerably less than the Abu Dhabi Investment Authority ($875bn). Further, the size of CIC relative to the total value of the assets in the top ten funds is even smaller at just 7.8 per cent. Currently, sovereign wealth funds globally are worth an estimated $3.3 trillion. This money is, at present, concentrated in the Middle East as a result of trade This paper is based on a thematic case study that the authors wrote for a report on Asian Financial Centres for the City of London, The Future of Asian Financial Centres – Challenges and Opportunities for the City of London, October 2008.

Journal of Financial Regulation and Compliance Vol. 17 No. 1, 2009 pp. 9-15 q Emerald Group Publishing Limited 1358-1988 DOI 10.1108/13581980910934009

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Table I. Top ten sovereign wealth funds

Fund

Region

Abu Dhabi Investment Authority Government of Singapore Investment Corporation Norwegian Government Pension Fund Saudi Arabia (various) Kuwait Investment Authority China Investment Corporation Stabilization Fund of the Russian Federation Temasek Holdings Qatar Investment Authority Algeria Total

Middle East Asia Europe Middle East Middle East Asia Europe Asia Middle East North Africa

Assets ($bn) Founded Source 875 330 322 300 250 200 127 108 50 42 2,604

1976 1981 1990 NA 1953 2007 2008 1974 2005 2005

Oil Non-commodity Oil Oil Oil Non-commodity Oil Non-commodity Oil Oil

Note: The table has been updated by the authors to include the newly established Stabilization Fund of the Russian Federation Source: Morgan Stanley Research (2007)

surpluses from oil production. However, it has been estimated that by 2015 sovereign wealth could amount to as much as $12 trillion with up to 50 per cent of these funds being in Asia (Morgan Stanley Research, 2007). In line with such projections, CIC is expected to receive more funding from the Chinese Government in the future with some estimates of the total value of the fund increasing to $300bn (FT.com, 2007). CIC’s current investments and strategy The initial foreign investments that CIC has made were almost exclusively in large US financials, namely, Blackstone ($3bn), Visa ($200 m), Morgan Stanley ($5bn) (Table II). These investments despite being substantial have mixed success. Since investing in Visa the share price has risen by 30 per cent while shares in Blackstone and Morgan Stanley have a fallen by 50 and 20 per cent, respectively[1]. The choice of these investments is particularly interesting. In an interview, Wang Jiangxi, Head of Risk at CIC, said that the decision to invest in both the Blackstone and Visa IPOs was down to the domestic experience of IPOs in China (Nangfang Daily, 2008b). The returns to some of the IPOs in Shanghai have been spectacular. Just six months after listing the average return on the IPOs of the newly listed Chinese banks was 74.3 per cent[2]. The Chinese experience of IPO investment has been of huge returns and so large US IPOs must have appeared particularly attractive and a sound initial foray into international investment.

Table II. CIC international investments

Company name

Industry

Blackstone Visa Morgan Stanley JC Flowers Veolia Environment SA

Financial Financial Financial Financial Environmental services

Sources: Morgan Stanley (2008) and Bloomberg (2008)

Percentage holding (per cent)

Value $bn

10 2.5 9.9 80 1.5

3.0 0.2 5.0 4.0 0.3

However, the more recent investment in Morgan Stanley by CIC suggests an evolving investment strategy. As a result of the losses incurred from investment in sub-prime mortgages many banks have sought finance from sovereign wealth funds to help re-capitalise their balance sheets. Citigroup, having incurred some of the highest losses, approached China Development Bank (CDB) for investment. However, as a state run bank CDB had to seek government approval for the deal and requested three days to reach a decision. At the same time, the Abu Dhabi Investment Authority was in talks with Citigroup and was able to invest immediately and CDB lost out on the deal. As result of CDB losing out on the Citigroup investment, when CIC was approached by Morgan Stanley the deal went through without the lag that hampered the CDB/Citigroup deal. The fund is therefore making investments more autonomously from the central government in China (Financial Times, 2007). Further, CIC has also started to change the structures of the deals that they are undertaking. CIC has undertaken a joint venture with JC Flowers, a US private equity firm, to launch a new $4bn private equity fund that will focus on investments in US financial assets. As part of the deal CIC will become a limited partner in the new private equity fund providing about 80 per cent of the capital with JC Flowers investing approximately 10 per cent and the remainder coming from other investors. This deal is unusual however as JC Flowers will be investing around 10 per cent while deals of this nature usually only require the private equity firm to inject around 1-2 per cent. In structuring the deal this way, CIC incentives and binds JC Flowers to the deal as the private equity firm will bear more of the risk from any investments that it makes[3]. As part of its investment strategy going forward CIC has also stated that the fund will be moving away from financials into other markets (Financial Times, 2007). To this end, CIC has acquired a 1.5 per cent stake in Veolia Environment SA ($275 m), the biggest water company in the world. This shows that the strategy of CIC is already changing as it is diversifying its holdings away from financials. However, this investment has moved the fund into a more politically sensitive area, namely utilities and investments by sovereign funds in such strategic assets raises protectionist sentiments in governments around the world. Consequently, the fund may find that some deals are more difficult to execute because of resistance by governments and regulators around the world. The international politics of CIC investment As a government backed investment fund CIC will clearly receive considerable attention from the government and regulators of the countries in which they are investing. To date the only country that has openly stated that it is not opposed to investment by CIC is the UK. The response of the UK has been that investments in UK corporations or the use of London as a centre for managing CIC funds is welcome, subject to compliance with existing UK regulation. Many other countries have been considerably less welcoming and much more vocal in their opposition to sovereign wealth funds. This protectionist stance has been most vocal in the USA, Germany and France all of whom have explicitly stated that they will act to protect national interests in the face of politically motivated investment. Most recently, France has set up its own sovereign fund to “intervene massively” in

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companies of national strategic importance to prevent foreign sovereign wealth funds investing (France Announces Sovereign Wealth Fund, 2008). The USA in particular has taken a very strong protectionist stance and in this is especially true with respect to CIC. This was highlighted in a report produced for Congress only six months after CIC was created. The report suggested a number of policy responses to the emergence of CIC. These include a global code of conduct for sovereign wealth funds, a step that has also been advocated by the EU Trade Commissioner, Mandelson (2008). More provocatively, the report also suggests that US laws might be redrawn to limit where and in what industries sovereign wealth funds can invest as well as imposing stricter financial reporting requirements on them (China’s Sovereign Wealth Fund, 2008). Underpinning all of these factors is the need for transparency. The fear of strategic assets being brought under the proxy control of a foreign government is understandable. As a result, the International Monetary Fund (IMF) and the Organisation for Economic Co-operation and Development (OECD) are pressing for a global code of conduct for sovereign wealth funds to increase transparency and make clear their objectives and governance. To this end, the International Working Group of Sovereign Wealth Funds, which is made up 26 sovereign wealth funds including CIC, reached a preliminary agreement on a draft code of principles and practices on 2 September 2008. These generally accepted principles and practices for sovereign wealth funds cover governance, accountability and investment practice for sovereign wealth funds. This is however only a draft proposal and it must now be agreed by each fund’s respective government (Santiago Principles, 2008). Adoption by CIC is however uncertain, as CIC has explicitly objected to the implementation of such a code. In an interview on US television, the General Manager of CIC, Gao Xiqing, insisted that it will not seek control of any of its investment targets and so believed an international code of conduct is unnecessary. The domestic politics of CIC investment Most of the current media attention on CIC focuses exclusively on how the fund invests and the relationships that CIC has with the target company’s government. CIC is however a state backed fund, and must also therefore be sensitive to domestic policy concerns. This relationship has already impacted upon the emergent strategy of CIC with regards to where it invests and in what companies CIC invests. In March of this year, CIC were in intensive negotiations with Allianz SE to buy their banking arm, Dresdner Bank (Sueddeutsche Zeitung cited in Reuters News (2008)). However, CIC subsequently walked away from the deal citing investment risk and political problems. This is thought to be because relations between Germany and China have cooled since the German Chancellor, Angela Merkel, met with the exiled Tibetan Leader, the Dalia Lama. As a state back fund CIC are by proxy representing the interests of the Chinese Government and so CIC walked away from the deal as this may have led to political difficulties at home (Reuters News, 2008). Consequently, CIC may be unlikely to invest in countries/regions where the political reaction is hostile or where diplomatic relations with the Chinese Government are strained. Although CIC is viewed as a strategic investment vehicle it must also generate a return on its investments. The need to be successful and make sound investments is

even more apparent given the cost of CIC servicing its debt is $30m every day (Financial Times, 2008). Further, if CIC is to be given subsequent funds this will only become reality if the fund performs well and makes sound investments over the long-term. CIC is clearly under considerable pressure not just from the Chinese Government, but the Chinese public in terms of making sound investments. There is a popular awareness of CIC’s activities in managing the country’s reserves and any significant losses are likely to generate large amounts of adverse publicity. This has been apparent from the Blackstone investment. Having made significant losses on the investment in Blackstone CIC was widely criticised in the Chinese media. Many in China viewed the investment as hasty, badly timed and a demonstration of CIC’s inexperience in appraising investments and their associated risks (Beijing Review, 2008). Implications for global financial markets One impact that CIC will have on financial markets in the near future is deciding who will manage their foreign assets. A number of large international companies have been rumoured to be in the running including, Goldman Sachs, Morgan Stanley, UBS, and Invesco. There are also two Chinese companies who have submitted bids. One is China International Capital Corporation, who successfully tendered to manage a portion of the National Social Security Funds international investments in a joint venture with Goldman Sachs. The other is China Life, an insurance company, in a joint venture with Franklin Templeton, an US asset management company (Nangfang Daily, 2008a). The tender process, however, has not been without some controversy as the design of the asset allocation plan was given to exclusively to Morgan Stanley, a company in which CIC is the second largest shareholder. Some commentators have expressed concerns that Morgan Stanley (2008) may weight the plan towards investments that reflect the expertise of the firm. Further, the fund is already showing signs of being an influential investor in global financial markets. Most recently, HSBC’s (Hong Kong) shares jumped 4.1 per cent, their biggest one day rise in four months, on rumours that CIC was talking with the company about investing. The Chairman of HSBC, Stephen Green, met with CIC several times and one of the rumours was that CIC would buy shares in HSBC on the open market. Investors viewed the deal as being good for HSBC with one analyst commenting (The Sunday Telegraph, 2008): If this report is true, clearly it will be positive for both parties.

In terms of the impact on the financial services industry, the development and growth of CIC will result in a huge demand in financial services. Recent examples of firms that have benefited from CIC outsourcing projects are McKinsey, a management consulting firm, who assisted in the organisational design in the initial stages of the setting up of CIC. Morgan Stanley has also benefited as CIC appointed them to be the lead consultant on formulating CIC’s global asset allocation plan. The importance of CIC setting up representative offices in global financial centers is also clear. As a consequence, there has been considerable speculation and the potential location of these offices as the financial centers where CIC locates to will benefit from the funds demand for local financial services and expertise.


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Most recently, there has been considerable media coverage with regards to CIC setting up representative offices in Tokyo after Gao Xiqing’s visit to Japan. However, CIC may move slowly in setting up their operations across global financial centres. In China, for example, Shanghai is the centre of the financial industry, and so it would be the logical place for CIC to be based. CIC, however, is still currently located in Beijing with most other Chinese Government bodies and has yet to set up a presence in China’s domestic financial centre, let alone in global centres. Conclusions The growth in sovereign wealth globally has resulted in a significant amount of debate as to its role and the underlying motives for the investments that are made by these funds. This is evident from the intense media scrutiny and extensive debate on sovereign wealth in political arenas such as the US Congress, the OECD, the IMF and the EU. CIC has been the focus of much of this debate, especially in the USA, where there have been calls for protection of key strategic assets (China’s Sovereign Wealth Fund, 2008). This is despite CIC being less than one-year old and accounting for only a small fraction of Asian and Global sovereign wealth. CIC however has made a number of large high-profile investments, although with varying success. From these deals however, it is clear that CIC’s investment strategy is evolving. The initial investments in the IPOs of Blackstone and Visa were driven by the limited experience of Chinese IPOs which have been remarkably successful. However, their investments in Morgan Stanley and JC Flowers are a definite shift in the strategy of the fund. The Morgan Stanley deal was completed with a high degree of autonomy from the centre in China, and the JC Flowers investment imposed a unique structure on the deal. Further, the latest investment in Veolia Environment SA, the worlds largest water company, also highlights a move away from financials into more (potentially controversial) strategic assets. In the near future CIC will be appointing fund managers and possibly setting up international representative offices. This is going to have a large impact on the major financial centres around the world where these tender bids are successful. Successful bidders will be allocated substantial amounts of funds to manage and with this will come a demand for local expertise and financial services such as legal advice, risk management, consultancy, human resources and training. Notes 1. These figures were correct in August 2008, however, given the recent financial turmoil the actual performance of these investments may be markedly different than reported here. 2. The listing of Chinese SOE banks and their path to banking and ownership reform: a case study approach, working paper. 3. China Daily, CIC, JC Flowers to open up $4bn fund for US deals. References Beijing Review (2008), “Profits don’t come easy”, Beijing Review, 30 April. Bloomberg (2008), “Veolia environment gets investment from China fund CEO says”, Bloomberg, 7 August.

China’s Sovereign Wealth Fund (2008) CRS Report for Congress, China’s Sovereign Wealth Fund, Beijing, 22 January. (The) Financial Times (2007), “China’s CIC likely to diversify away from further US banking sector investments”, The Financial Times, 30 December. (The) Financial Times (2008), “CIC has $90bn to spend on assets abroad”, The Financial Times, 24 April. France Announces Sovereign Wealth Fund (2008), available at: www.rte.ie (accessed 22 October 2008). FT.com (2007), “Sovereign wealth funds and the $2500bn question”, Alphaville, 25 May. Mandelson, P. (2008), “Putting sovereign wealth in perspective”, speech, 28 March. Morgan Stanley (2008), Fierce Competition in Bidding to Manage CIC Assets, Morgan Stanley, New York, NY, available at: china.org.cn (accessed 1 July 2008). Morgan Stanley Research (2007), How Big Could Sovereign Wealth Funds Be by 2015?, Morgan Stanley Research, London, May. Nangfang Daily (2008a), Nangfang Daily, 18 March. Nangfang Daily (2008b), Nangfang Daily, 3 April. Reuters News (2008), “China bank turns down German Dresdner deal”, Reuters News, 28 March. Santiago Principles (2008), International Working Group of Sovereign Wealth Funds Reaches a Preliminary Agreement on Draft Set Generally Accepted Principles and Practices – “Santiago Principles”, 2 September. (The) Sunday Telegraph (2008), “CIC to invest in HSBC”, The Sunday Telegraph, 20 July. Corresponding author Iain Clacher can be contacted at: [email protected]

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JFRC 17,1

Japan: the banks are back! Or are they? Maximilian J.B. Hall

16

Department of Economics, Loughborough University, Loughborough, UK Abstract Purpose – The purpose of this paper is to demonstrate how Japanese bank “performance” has improved markedly since fiscal 2003 but to caution against over-optimism. Design/methodology/approach – The methodological approach adopted involves using aggregate balance sheet data dating from around 1990 to identify the trends in industry performance with respect to profitability, asset quality and capital adequacy. Findings – The bursting of the asset price bubble in the early 1990s clearly had a major adverse impact on “performance”, as measured by the above-mentioned indicators, but, after fiscal 1992, the industry’s fortunes began to improve. Problems on each front, however, remain to be resolved. Practical implications – By identifying the main problems still besetting the Japanese banks, both the industry and their supervisors are given advice as to which areas they need to focus on to improve future bank performance. Originality/value – The paper clearly explains the nature of, and reasons for, the recent improvement in Japanese bank performance whilst highlighting the areas on which they still have to focus if they are to regain their former glory within the international banking community. It should be of interest to all serious scholars of the Japanese banking system and interested commentators alike. Keywords Japan, Banking, Performance measures, Capital profit, Equity capital, International banks Paper type Research paper


1. Introduction Apart from turning the tide on the non-performing loan (NPL) front, most performance indicators at the end of fiscal 2002 (i.e. at end-March 2003) painted a fairly bleak portrait of the Japanese banking sector. Return on assets and on equity were negative; core and net capital were in steady decline, with deferred tax assets (DTAs) assuming a growing share of core capital; and the sector was heavily exposed to equity risk, credit risk and interest rate risk (IMF, 2003; Hall, 2006). At end-March 2004, however, five of the top seven banking groups (UFJ Holdings and Resona Holdings – Resona Bank had to be rescued by the Government in May 2003 – were the odd ones out) posted net profits for the first time in three years, with the sector returning to overall profitability in fiscal 2004. And the following year, record profits were recorded by the banking industry. This remarkable turnaround, together with the associated reduction in financial fragility, are analysed in more detail below, together with the formidable problems still besetting the sector. The paper is structured as follows. The next section reviews the structure of the Japanese banking sector as it stood at end-March 2007 following further consolidation and rationalisation. Section 3 analyses the latest trends in bank “performance”, in terms of profitability, asset quality and capital adequacy. Section 4 looks at the challenges still facing the sector. And Section 5 summarises and concludes. The financial support of the Daiwa Anglo-Japanese Foundation is gratefully acknowledged.

2. The structure of the Japanese deposit-taking sector As shown in Table I, at end-March 2007 there were over 200 banks proper operating in Japan with more than 1,500 cooperative-type institutions also active as deposit-takers. The former group comprised six city banks, 64 regional banks, 46 second association regional banks, 65 foreign banks, 21 trust banks and ten “others”. Continued consolidation amongst the major banks has meant that four major banking groups – Mitsubishi UFJ, Mizuho, Sumitomo Mitsui and Resona – now dominate the banking scene in Japan (Table II), with the “Long-term credit bank” categorisation finally disappearing as a separate sub-group. (For a discussion of the operations performed by the various categories of bank and co-operative, see Japanese Bankers’ Association (2001)).

Japan: the banks are back!

17

3. Recent trends in bank performance 3.1 Profitability As can be seen from Table III, the banking industry’s performance was dire between fiscal 1995 and 2002, largely as a result of the collapse of Japan’s asset price bubble and stagnation in the real economy. Indeed, during this period, net losses were recorded for each of the years 1995, 1997, 1998, 2001 and 2002. Whilst lending margins and gross profits remained fairly stable, net operating profits were negative from fiscal 1993 onwards because of the impact of disposing of huge amounts of NPLs on “loan losses”. The fall in the value of securities held and the introduction of mark-to-market accounting also meant that, after fiscal 2001, banks were unable to boost profits by realising capital gains. With the pick-up in the real economy (albeit at a sluggish pace) from 2003, largely due to export-led recovery because of a low-exchange rate, and knock-on effects for corporate Japan and the stock market, the banking sector’s fortunes began to improve. Banksa

Cooperatives

City Banks (6) Regional Banks (64) Second Association of Regional Banks (46) Foreign Banks (65) Trust Banks (21)b Others (10)c Shinkin Central Bank Shinkin Banks (287) Shinkumi Federation Bank Credit Cooperatives (168) Rokinren Bank Labor Banks (13) Norinchukin Bank Credit Federation of Agricultural Cooperatives (41) Agricultural Cooperatives (835) Credit Federations of Fishery Cooperatives (31) Fishery Cooperatives (181)

Notes: Figures in parentheses represent the number of institutions in each category operating at 1 April 2007. aIncluding 10 bank holding companies; bincluding foreign-owned trust banks; cincluding the Second Bridge Bank of Japan and the Resolution and Collection Corporation Source: Japanese Bankers’ Association (2007, p. 1)

Table I. Categorisation of private depository institutions operating in Japan

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Merged entities

Date of merger

New entity formed

Latest developments

Dai-Ichi Kangyo Banka, Fuji Banka, Industrial Bank of Japanb, Mizuho Trustc (jointly owned)

September 2000

Mizuho Holdings, comprising: Dai-Ichi Kangyo Banka; Fuji Banka; Industrial Bank of Japanb; Mizuho Trustc

Mizuho Holdings (renamed Mizuho Financial Group in March 2003), comprising (at April 2002): Mizuho Banka; Mizuho Corporate Banka; Mizuho Trustc Sumitomo Mitsui Financial Group, comprising (at December 2002): Sumitomo Mitsui Banking Corporationa Mitsubishi Tokyo Financial Group, comprising (at October 2001): Bank of Tokyo-Mitsubishia; Mitsubishi Trustd

18

Table II. Consolidation amongst the major Japanese banks, 2000-2006

Sakura Banka, Sumitomo April 2001 Banka

Sumitomo Mitsui, Banking Corporation

Bank of Tokyo Mitsubishia – Tokyo Trustc, Mitsubishi Trustd, Nippon Trustd

April 2001

Sanwa Banka, Tokai Banka – Tokai Trustc, Toyo Trustd

April 2001

Daiwa Bank Holdings, comprising (at December 2001): Daiwa Banka; Kinki Osaka Banke; Nara Banke; Asahi Banka; Asahi Trustc Mitsubishi Tokyo Financial Group UFJ Holdings

March 2002 (effective October 2002)

Mitsubishi Tokyo Financial Group, comprising: Bank of Tokyo-Mitsubishia; Mitsubishi Trustd; Nippon Trustd; Tokyo Trustc UFJ Holdings, comprising: Sanwa Banka; Tokai Banka; Toyo Trustd; Tokai Trustc Resona Holdings, comprising: Daiwa Banka; Asahi Banka; Kinki Osaka Banke; Nara Banke; Daiwa Trustd

October 2005 (effective January 2006)

UFJ Holdings, comprising (at January 2002): UFJ Banka; UFJ Trustd

Resona Holdings, comprising (at March 2003): Resona Banka; Saitama Resona Banka; Kinki Osaka Banke; Nara Banke; Resona Trustd Mitsubishi UFJ Financial – Group

Notes: aCity bank (in 2004 the Saitama Resona Bank was reclassified as a regional bank); blong-term credit bank; ctrust bank subsidiary; dtrust bank; eregional bank Source: Japanese Bankers’ Association (2006, p. 14)

Although the sector, overall, did not return to profitability until fiscal 2004 [1], with the major banks reporting positive net income for the first time in four years and the regional banks for the first time in ten years, five of the top seven banking groups had, in fact, reported net profits in fiscal 2003, as noted in the introduction. Continued economic recovery during 2004/2005 [2], a return to positive bank lending [3] and cessation of deflation [4] contributed to a record profits performance by the sector in fiscal 2005 as loan losses fell dramatically and a recovery in stock prices allowed for the realisation of capital gains again. Fiscal 2006 saw the industry reporting very healthy [5], if slightly lower – because of a slight decrease in interest margins, a fall in non-interest income and an increase in credit costs associated with exposures to the consumer finance industry as a result of changes in the law relating to the so-called usurious (although the legal maximum was retrospectively cut to 29.2 per cent,

9.2 9.7 10.8 10.8 10.0 9.6 9.7 9.4 9.8 9.4 2.8 2.1 3.5 3.6 3.6 3.1 2.5 3.0 3.1 3.6 7.8 7.8 7.8 8.0 7.9 7.5 7.3 7.1 7.0 7.0 4.3 4.0 6.5 6.4 5.7 5.2 4.9 5.3 5.9 6.0 4.7 6.2 13.3 7.4 13.4 13.5 6.3 6.6 9.4 7.0 2 0.4 22.2 26.8 2 1.0 27.7 28.3 2 1.4 21.3 23.5 2 1.0 2.0 3.2 4.4 1.2 3.6 1.4 3.8 1.4 22.4 2 4.1 1.7 1.0 22.4 0.2 24.1 26.9 2.3 0.1 25.9 2 5.1

Sources: Japan Center for Economic Research (2003) and Fukao (2007)

9.8 2.5 7.7 4.5 2.0 2.5 0 2.5

9.0 4.3 6.7 6.6 6.1 0.5 0.6 1.1

8.7 4.6 6.4 6.9 4.2 2.7 20.1 2.6

8.7 5.2 6.5 7.4 2.0 5.4 0.5 5.9

8.5 4.3 6.5 6.3 1.7 4.6 0.2 4.8

7.1 2.6 7.1 2.6 0.8 1.8 2.0 3.8

Lending margin ((i)) Other revenue ((ii)) Operating costs ((iii)) Gross profit ((iv) ¼ (i) þ (ii)-(iii)) Loan loss (v) Net operating profit ((vi) ¼ (iv)-(v)) Realised capital gains ((vii))) Net profit ((vi) þ (vii))

8.9 2.2 7.5 3.5 1.0 2.5 0.7 3.3

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Financial year


19

Table III. Profitability of the Japanese banking sector, 1990-2007 (¥ trillion)

JFRC 17,1

borrowers were seeking refunds on loans charging over 20 per cent) “grey zone loans” (see Bank of Japan, 2007, for a more detailed analysis – profits). But, in fiscal 2007, sharply lower profits were reported due mainly to the continuing impact of exposures to the consumer finance industry (i.e. loans to and investments in consumer finance companies, consumer credit companies and credit card companies) and, for some, to the US sub-prime market [6] (Bank of Japan, 2008).

20 3.2 Asset quality The trend in the Japanese deposit-taking sector’s “bad” (i.e. “risk management”) loans is clearly indicated in Table IV. Hitting a peak of ¥53 trillion at end-March 2002, it was down to ¥18.4. trillion by end-March 2007. In part, this reflects the success of the Financial Services Agency’s (FSA) plan to force the major banks to halve their NPL ratios between end-March 2002, when the combined ratio stood at 8.4 per cent, and end-March 2005. As demonstrated in Table V, the major banks’ combined ratio was down to 2.9 per cent by end-March 2005, with further declines taking it down to 1.5 per cent by end-March 2007, a level maintained at end-September 2007, the latest date for which figures are available (FSA, 2008). At 3.9 per cent, the latest figure for the regional bank grouping also represents a substantial improvement on the recent past (e.g. it was 7.8 per cent at end-March 2003), although some regional banks are still operating with ratios substantially in excess of this figure. The performance during fiscal 2007, however – as noted above – is likely to reverse this declining trend somewhat, but hopefully only temporarily. 3.3 Capital adequacy Despite all groups of banks posting figures demonstrating compliance with capital adequacy requirements, be they of the risk-adjusted type applied to internationally-active banks under the risk assets ratio (minimum 8 per cent) methodology of the Basel Accord or of the type applied to domestic-only operators (where a 4 per cent minimum ratio applies), this apparently happy state of affairs masked serious problems during the post-bubble era. As shown in Table VI: core capital was in steady decline between 1995 and 1998 and again between 2001 and 2003, reflecting the decline in the banks’ profitability and the inability to issue common stock, at a reasonable price, because of the declining value of a bank franchise; net capital (i.e. after allowing for post-tax revaluation gains on securities held) was likewise in steady decline between 1994 and 1998 and again between 2000 and 2003, reflecting gyrations in the value of their securities; after 1998, DTAs represented a significant proportion of net capital; and, following capital injections by the Deposit Insurance Corporation (DIC) towards the end of the century in an attempt to stabilise the banking and financial sectors (Hall, 2006), from 1999 a significant chunk of core equity capital was held by the government reflecting the degree of “nationalisation” instituted by the authorities. Since 2003, however, these problems have become less important. The recovery in bank profitability has put core and net capital on an upward trend since 2003. DTAs as a proportion of capital are now much less significant [7]. And the proportion of privately-held net capital has increased since 2003 as banks have repaid some of the earlier DIC capital injections [8]. Notwithstanding these undoubted improvements in both the quality and quantity [9] of bank capital at a time when exposures to credit risk, interest rate risk

Date End of March 1992 End of March 1993 End of March 1994 End of September 1994 End of March 1995 End of September 1995 End of March 1996 End of September 1996 End of March 1997 End of September 1997 End of March 1998 under “old” disclosure standards Under “new disclosure” standards End of March 1999 End of March 2000 End of March 2001 End of March 2002 End of March 2003 End of March 2004 End of March 2005 End of March 2006 End of March 2007

“Bad” loans outstanding Stock of specific provisions Estimate of “problem (¥ billion) outstanding (¥ billion) loans to be disposed of”a (¥ billion) 7,000-8,000b 8,400b 10,500b 13,300b 11,640b 38,086c 34,799e,f 29,228 g,h 27,900i,j 28,078k,l

– – – – – 6,961 12,530e 9,948 g 12,343i 13,993k

– – – – – 18,587d 8,305e 7,303 g 4,685i 4,348k

24,979 m,n

NA

NA

35,207 m,n 38,656 41,367p 43,448q 53,049r 45,676r 35,851 25,840 20,284 18,354

19,035 m 14,802 11,500p 10,039q 10,375r 8,569r 7,775 6,384 4,583 4,297

1,583 m,o NA NA NA NA NA NA NA NA NA

Notes: aThis figure represents an estimate by the Ministry of Finance of the scale of loans for which possible losses have not been provided nor that are likely to be covered by collateral (i.e. loan losses considered “irrecoverable” and not provided for). bMinistry of Finance estimate of “NPLs” for the 21 largest banks. Figures include claims against customers who went bankrupt and claims on which interest payments were more than six months overdue due to the suspension of interest payments, but exclude “restructured loans” (i.e. those on which interest payments have been cut) and the bad debts of affiliates. cFigures include “restructured loans” (i.e. loans on which interest rates have been reduced to below the ruling official discount rate) for the first time and now cover all Japanese deposit-taking financial institutions (i.e. city banks, long-term credit banks, trust banks, regional banks and co-operatives). dThe figure is inclusive of possible losses (estimated at ¥7,700 billion) resulting from exposure to the eight jusen companies. eThe figures exclude the Kizu Cooperative (with about ¥1,190 billion in problem loans), the Fukui Prefecture First Credit Cooperative (¥2.6 billion), the Osaka Credit Cooperative (¥270 billion), and Taiheiyo Bank (¥330 billion). fThe figure excludes loans to borrowers to which the lending bank(s) is extending help (including forgiving loans), estimated at ¥3,795 billion for all “major” banks (i.e. excluding regional banks and co-operatives) at end of March 1996. gLoans to jusen companies are excluded, as are the Kizu Credit Cooperative (with approximately ¥1,190 billion in problem loans), the Osaka Credit Cooperative (¥270 billion), the Kenmindaiwa Credit Cooperative (¥15 billion), and Sanyo Credit Cooperatives (¥17 billion). hThe figure excludes loans to borrowers to which the lending bank is extending help (including forgiving loans), estimated at ¥3,724 billion for all “major” banks (i.e. excluding regional banks and co-operatives) at end of September 1996. iThe figures exclude the Hanwa Bank (with around ¥190 billion in problem loans), the Sanpuku Credit Cooperative (¥26 billion), and the Hanshin Labor Credit Cooperative (¥3.5 billion). jThe figure excludes loans to borrowers to which the lending bank(s) is extending help (including forgiving loans), estimated at ¥3,373 billion at end of March 1997 for all “major” banks (i.e. excluding co-operatives but including regional banks for the first time). kThe figures exclude the Hokkaido Takushoku Bank, Hanwa Bank, Hanshin Labor Credit Cooperative, Tokai Credit Cooperative, Toki Credit Cooperative, Kitakyushu Credit Cooperative, Kanagawa Credit Cooperative, Tanabe Credit Cooperative, and the Choginosaka Credit Cooperative. lThe figure excludes loans to borrowers to which the lending bank(s) is extending help, estimated at ¥3,084 billion at end of September 1997 for all major banks (as defined in note 10). mThe figures exclude the Hokkaido Takushoku Bank, Tokuyo City Bank, Kyoto Kyoei Bank, Naniwa Bank, Fukutoku Bank, Midori Bank, and 32 credit companies whose assets and liabilities have been transferred to other institutions. nThe figure excludes loans to borrowers to which the lending bank(s) is extending help, estimated at ¥2,015 billion at end of March 1998 for all Japanese deposit-taking institutions. oThe figure was provided privately to me by the FSA. pThe figures exclude the Nippon Credit Bank. qThe figures include the Nippon Credit Bank but exclude the Tokyo Sowa Bank, Niigata Chuo Bank and bankrupted co-operatives. rThe figures exclude financial institutions which were declared bankrupt Sources: Hall (2000) and FSA (2007, 2008)


21

Table IV. The evolution of the “bad” (i.e. “risk management”) loans of the Japanese deposit-taking sector, 1992-2006

Table V. Recent trends in banks’ NPLs (8.7) (7.9) (9.1) (8.4) (7.7) (9.0) (8.4)

176,690 4,360 25,750 202,440 105,890 38,990 353, 390

(7.3) (5.8) (6.6) (7.2) (7.6) (8.9) (7.4)

118,490 1,860 17,670 136,160 94,440 31,950 265,940

(5.3) (2.9) (4.7) (5.2) (6.8) (7.5) (5.8)

End-March 2004 (per cent)

Notes: ¥100 m/per cent. As defined under the “Financial Reconstruction Law” Source: FSA (various)

218,120 27,420 38.310 267,820 107,810 40,410 432,070

End-March 2003 (per cent) 64,630 1,500 9,470 74,100 76,740 25,870 179,270

(3.0) (2.4) (2.7) (2.9) (5.5) (6.3) (4.0)


40,650 640 5,660 46,300 63,830 22,080 133,720

(1.8) (0.9) (1.6) (1.8) (4.4) (5.3) (2.9)


22

City banks Long-term credit banks Trust banks Major banks Regional banks I Regional banks II All banks


35,090 610 5,740 40,830 58,150 19,270 119,740

(1.5) (0.7) (1.6) (1.5) (3.9) (4.5) (2.5)


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30.2 31.3 31.8 32.3 32.3 27.9 28.5 24.5 33.7 35.2 36.7 29.3 24.8 29.0 31.4 37.3

77.7 56.4 56.4 61.9 52.0 64.3 54.1 50.8 47.1 54.5 44.5 34.4 23.2 28.5 27.7 3.2

33.1 34.5 34.5 36.5 39.8 43.0 42.9 45.7 42.7 44.4 44.3 34.4 23.2 28.5 27.7 22.2

(iii) Book value of shares held 26.7 13.1 13.1 15.2 7.3 12.8 6.7 3.1 2.6 6.1 0.1 0 0 0 0 0

( ¼ 0.6((ii)-(iii))b)

(iv)

57.0 44.4 44.9 47.5 39.6 40.7 35.2 27.6 36.3 41.3 36.8 29.3 24.8 29.0 31.4 37.3

(v) Net capital ( ¼ (i) þ (iv)) 0 0 0 0 0 0 0 0 8.4 8.1 7.3 10.7 10.6 7.2 5.7 2.3

0 0 0 0 0 0 0 0.3 6.3 6.9 7.1 7.2 7.3 8.9 8.1 5.2

(vii) Core equity capital held DTA by government

(vi)

57.0 44.4 44.9 47.5 39.6 40.7 35.2 27.3 30.0 34.4 29.7 22.1 17.5 20.1 23.3 32.1

(viii) Privately-held net capital ( ¼ (v)-(viii))F

Notes: aEquivalent to unconsolidated Tier 1 capital; breflects a 40 per cent deferred tax liability rate. ¥ Trillion, unconsolidated data Sources: Japan Center for Economic Research (2003) and Fukao (2007)

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

(i) (ii) Period Core Market value of (end-March) capitala shares held


23

Table VI. Aggregate capital held by Japanese banks, 1991-2007

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and market risk (incurred through stock holdings) were also generally falling [10] – thereby reducing overall financial fragility – some questions remain about the capital adequacy assessment regime. These are addressed in the next section. 4. Challenges still facing the Japanese banking sector 4.1 Profitability Despite the recent improvements in profitability noted in Section 3.1, which saw major banks achieving a return on equity (ROE) of 16 per cent in fiscal 2005 – almost on a par with major US/EU banks – compared with a figure of over 7 per cent posted by regional banks, this has resulted mainly from the sharp reduction in credit costs enjoyed as a result of the reduced need to make allowance for loan losses once the NPL problem came under control. This has led economists at the Bank of Japan to develop a profitability measure that excludes volatile factors, such as credit costs, gains/losses on securities and corporate income tax payments. Their preferred measure (Hattori et al., 2007), is “core ROE”, where the above-mentioned volatile items are stripped out of ROE, defined as net income as a proportion of common stock plus preferred stock. Using this measure of profitability, the major banks as a group (there is large discrepancy between individual banks) are shown to have secured only a slight increase – from 0.7 to 1.7 per cent – in profitability between fiscal 2003 and fiscal 2005, with the regional banks failing to show any improvement! For the major banks, the limited increase in core ROE was due to net income increasing by only fractionally more than equity. This, in turn, was mainly due to a fall in net interest income (the fall in interest income from loans exceeding the rise from securities) offsetting, to a degree, the increase enjoyed in non-interest income (e.g. from fees and commissions). The regional banks somewhat poorer performance reflected their slower growth in non-interest income for, whereas both groups of banks enjoyed increased fee income from the sale of mutual funds and pension/insurance policies, the major banks also enjoyed significant contributions from the origination of syndicated loans and the provision of commitment lines. The above analysis highlights the main factors still adversely impacting on bank profitability. For, although positive ROAs and ROEs are once again the norm, core ROEs are very low, both in absolute terms and relative to EU/G10 banks (Bank of Japan, 2007, pp. 47-50), because of weak growth in interest income – due to anaemic corporate loan demand and an inability to expand lending margins in a low nominal interest rate and highly competitive environment – and, for many, limited success in diversifying away from traditional lending activities [11]. Moreover, attempts to raise investment returns by diversifying away from stocks and bonds [12] (e.g. into structured products – such as RMBs, including those originated in Japan – credit products and hedge funds) have been shown to be fraught with danger; witness the fallout from the sub-prime turmoil discussed earlier. In the face of such difficulties, banks will need to try and boost profits earnt on their core business by improving their management of credit risk [13], restraining the increase in credit costs, raising lending margins and re-enforcing their fee-generating business (Hattori et al., 2007). Whilst the last two remedies will not prove easy in the current market environment [14], especially for regional banks given the major banks incursion into their traditional territory and the growing importance of the Japan Post Bank, the Post Office’s new banking arm [15], they are essential components of

an integrated strategy that should seek to identify comparative advantage and market demands and then deliver the chosen services in the most cost-effective way possible. For some, this may necessitate structural re-organisation to enable group capital to be used more efficiently (Bank of Japan, 2007). Whatever strategies are adopted, management expertise will be at a premium in the brave new world. From a policy perspective, the imperatives are to nurture the recovery in the real economy, to try to engineer a generalised recovery in land prices and to promote the efficiency and competitiveness of the Japanese banking sector through deregulation [16]. Further rationalisation within the regional bank sector should also be encouraged as some highly inefficient operators still exist, protected by the monopolistic practices still evident within the prefectural system. 4.2 Asset quality While the recent decline in NPL ratios, for both the major bank grouping and (most of) the regionals, towards international norms is to be applauded, the losses incurred on exposures to the consumer finance industry and on sub-prime-related products are a reminder of how quickly events can change. Risk management skills and policies must be up-rated if future losses on loans and investments are to be held to acceptable levels. 4.3 Capital adequacy Notwithstanding the recent increases achieved in both the quantity and quality of bank capital noted in Section 3.3 above, a number of reservations remain concerning the capitalisation of Japanese banks. With respect to compliance with the BIS “rules”, a stricter interpretation would see: some of the banks’ loan loss provisions, currently classified as general but which, in reality, are specific, being fully deducted from capital; a greater proportion of cross-shareholdings being deducted from capital (to overcome the problem of “double gearing”); and further restrictions being placed on the inclusion of DTAs in core capital. Moreover, a more realistic view needs to be taken by some banks of the value of loan collateral and borrowers’ capacity to repay, as reflected in NPL classifications and hence provisioning [17], a move which would further deplete reported bank capital ratios. 5. Summary and conclusions Since fiscal 2003, the “performance” of the Japanese banking sector has improved markedly, in tandem with that of the real economy. Record profits were revealed in fiscal 2005, with results for fiscal 2006 showing only a small fall from this peak, although results for fiscal 2007 were disappointing. Similarly, asset quality has generally improved, with NPL ratios now well below the historic highs recorded at end-March 2002, and market risks now somewhat lower than when the IMF conducted its infamous “Financial Stability Assessment Programme” stress tests back in 2003. Moreover, bank capital adequacy has generally improved, with both “Tier 1” ratios and overall, BIS risk-adjusted ratios (now Basel II compliant) typically approaching international norms and being comfortably in excess of regulatory requirements. And the quality of capital has also increased with less reliance now being placed on DTA as a source of capital. Yet things are not as healthy as this image portrays. Core profitability, once volatile factors such as credit costs are stripped from the figures, remains very weak, both in


25

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absolute terms and relative to EU/G10 averages. Lending margins remain wafer thin. Loan demand, most especially from corporates, is still sluggish. Land prices have yet to see a generalised recovery. And diversification from traditional lending activities is still limited, fee and commission income at the major banks, for example, accounting for around only 20 per cent of operating income. Similarly, with respect to asset quality, exposures to the US sub-prime market have delivered investment losses for some whilst exposures to the consumer finance industry since the passage of legislation concerning usurious “grey loans” have caused nasty blips in both NPL ratios and credit costs. Moreover, the issues surrounding continued “under-reserving” and regulatory tolerance of “double gearing” mitigate, to a degree, the successes achieved on the capital adequacy front. Overall, however, the Japanese banking sector appears to be firmly “back on track”, following its abysmal performance during the “lost decade”, now boasting some of the largest banks (by assets size) in the world, if not yet by ROE! The continuing challenges faced in intensely competitive domestic and international markets are, however, well understood. And rising nominal interest rates along with improved risk management capabilities are likely to deliver increasing benefits in the medium to long term. Notes 1. Although Table III actually shows the sector returning to profitability in fiscal 2003 because of a difference in coverage of institutions. 2. Real GDP grew by 2.8 per cent in 2005 and has remained positive since 2003. 3. Bank lending rose, for the first time in seven years, in August 2005. 4. The core consumer price index, which excludes perishable foods but includes fuel costs, returned to a positive level in November 2005, rising by 0.5 per cent in the 12 months to end-March 2006. By end-March 2008, the index had reached a ten-year high of 1.2 per cent due to rising food and energy prices but, stripping these items out, left a figure of only 0.1 per cent (and the GDP deflator was still 2 1 per cent). 5. Assisted by the removal of the competitive advantages enjoyed by the Postal Savings System and Postal Life-insurance through privatisation, and by the privatisation/scaling back of the operations of other government-sponsored financial institutions (Fukao, 2007). 6. At the end of January 2008, the major banks reported net losses on sub-prime-related products for the first nine months of fiscal 2007 of ¥600 billion, with the big three groups – Mizuho, MUFJ and SMFG – reporting net losses of ¥345 billion, ¥55 billion and ¥99 billion, respectively. In May 2008, however, when the full year’s figures were released, the major banks’ combined losses on such products were revealed to be ¥863 billion, with Mizuho, MUFJ and SMFG recording losses of ¥645 billion, ¥125 billion and ¥93 billion, respectively. For Mizuho and MUFG, these losses contributed to recorded falls in net profits for fiscal 2007 of 49.8 per cent and 27.7 per cent, respectively. SMFG, however, managed to marginally boost full year net profits, by 4.6 per cent; whilst the Resona Group, despite steering clear of sub-prime problems, still suffered a 55 per cent fall in net profits. For Mizuho, the bulk of whose sub-prime trades were booked through its brokerage office in London, the sub-prime-related losses resulted in the bank recording its first quarterly loss for five years. 7. Due, in part, to the introduction of a limit in March 2006 – 40 per cent of BIS core capital. This limit was then reduced to 20 per cent in March 2008. 8. By end-June 2007, ¥8.8 trillion of the near ¥12 trillion of capital injections had been repaid by the banking sector, the three mega banking groups having already fully repaid during fiscal 2006.

9. The transition to a Basel II basis of assessment for internationally active banks had little impact on reported ratios, although it did reduce risk-weighted assets for some (Bank of Japan, 2007). Most of the major banks adopted the foundation IRB approach, duly reporting overall risk-adjusted ratios of 12 per cent plus at end-March 2007, with Tier 1 ratios in excess of 7 per cent (the corresponding figures for regional banks were 10 per cent and 8 per cent, respectively). 10. The “infamous” stress tests conducted by the IMF (2003) in 2002 and 2003 showed how seriously exposed the sector at that time was to equity risk, interest rate risk and credit risk, especially if DTAs are stripped out of shareholders’ equity. 11. For the major bank grouping, fee and commission income represented only 20 per cent of operating income in fiscal 2006, with income from trading (e.g. forex and derivatives) and other sources amounting to 5 and 27 per cent of total operating income, respectively. This meant that the group’s reliance on interest income (from loans and securities investments) had shrunk between fiscal 2002 and fiscal 2006 as its share of total operating income fell from 57 to 49 per cent. As far as lending activities are concerned, in the face of weak demand from their traditional customers – large corporates – the banks have diversified into M&A and real estate financing, and the provision of housing loans to individuals and loans to SMEs. Moreover, some have returned to overseas markets in the quest for greater returns, with MUFG and SMFG seeking increased exposure through strategic investments in Merrill Lynch (MUFG has a $1.2 billion stake) and Vietnam’s Export-Import Commercial Joint Stock Bank (SMFG has a 15 per cent stake), respectively. 12. “Alternative investments” accounted for nearly 10 per cent of the total balance of “securities and monetary claims bought” for the major banks at end-September 2007, with the regional’s share standing at 7 per cent. 13. Through, for example, using more sophisticated credit-scoring techniques and portfolio credit risk models, making use of credit bureaus and adopting an integrated risk management approach. 14. Although a rise in market interest rates – policy rates are still at 0.5 per cent – would produce an adverse impact on bank profitability in the short run, because of the induced decline in the market value of bond portfolios, in the medium term it is likely to improve bank profitability by raising net interest margins, especially for the major banks. 15. It has over ¥189,000 billion in deposits and a network of 24,000 branches, making it the world’s largest bank on both counts. 16. Introduction of the so-called “Second Big Bang” set of reforms (FSA, 2007), embracing, amongst other things, proposals to lower the firewalls between banking and broking, is currently being held up because of a hung Parliament, with little legislative action now envisaged until January 2008 at the earliest. 17. See Fukao (2007) (Table VI) for an estimate of “under-reserving” during the fiscal 1997 to fiscal 2005 period (e.g. at end-March 2006, estimated under-reserving amounted to ¥8.3 trillion compared with a private net (core) capital account balance of ¥21.5 trillion).

References Bank of Japan (2007), Financial System Report, Bank of Japan, Tokyo. Bank of Japan (2008), Financial System Report, Bank of Japan, Tokyo. FSA (2007), Plan for Strengthening the Competitiveness of Japan’s Financial and Capital Markets, press release, Financial Services Agency, Tokyo.


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FSA (2008), The Status of Non-performing Loans as of End-September 2007, Financial Services Agency, Tokyo. Fukao, M. (2007), “Financial crisis and the lost decade”, Asian Economic Policy Review, Vol. 2, pp. 273-97. Hall, M.J.B. (2000), “What is the truth about the scale of Japanese banks’ bad debts? Is the situation manageable?”, Journal of Financial Services Research, Vol. 17 No. 1, pp. 69-91. Hall, M.J.B. (2006), “The Japanese banking system in the 21st century”, Special Issue of Papeles de Economica Espanola on “Comparative Financial Systems”, Vol. 110, pp. 145-65. Hattori, M., Ide, J. and Miyake, Y. (2007), “Bank profits in Japan from the perspective of ROE analysis”, Bank of Japan Review Paper, 2007-E-3, Bank of Japan, Tokyo. IMF (2003), “Japan: financial system stability assessment and supplementary information”, IMF Country Report No. 03/287, IMF, Washington, DC. Japan Center for Economic Research (2003), “Profitability of corporate, banking and life insurance sectors (in Japanese)”, Financial Research Report No. 8, Japan Center for Economic Research, Tokyo. Japanese Bankers’ Association (2001), The Banking System in Japan, Japanese Bankers’ Association, Tokyo. Japanese Bankers’ Association (2006), Japanese Banks, 2006, Japanese Bankers’ Association, Tokyo. Japanese Bankers’ Association (2007), Japanese Banks, 2007, Japanese Bankers’ Association, Tokyo. Further reading Japanese Bankers’ Association (2004), Japanese Banks, 2004, Japanese Bankers’ Association, Tokyo. Japanese Bankers’ Association (2005), Japanese Banks, 2005, Japanese Bankers’ Association, Tokyo. Corresponding author Maximilian J.B. Hall can be contacted at: [email protected]



Multinational banking in China after WTO accession: a survey

Multinational banking in China

Chen Meng Centre for International Business, University of Leeds, Leeds, UK and University of International Business and Economics, Beijing, People’s Republic of China

29

Abstract Purpose – The purpose of this paper is to understand the market entry dynamics of foreign banks in China. Design/methodology/approach – The paper employs multi-method approaches combining both questionnaires survey data and qualitative interviews. Also, integration of internalization theory (at the macro level) and strategy literature (at firm level). Findings – The paper clarifies why and how foreign banks enter the Chinese market, and strategies adopted to cope with local market dynamics; also, the paper identifies major trends and key competitive advantages of foreign banks. Practical implications – Major advantages and weaknesses have been identified, which will help foreign entrants to make greater inroads into the domestic banking market. The paper shows how to manage risks and make governance structure more efficient and transparent, which are urgent tasks for policy makers. Originality/value – The paper utilizes the first nation-based dataset to investigate the Chinese market, and offers practical implications for local regulators and policy makers and bankers. Keywords Multinational companies, Banks, China, Market entry, Emerging markets Paper type Research paper

Introduction Banking services share most of services nature of being intangible, non-storable and untransportable, and cannot be traded without requiring the providers or receivers to physically relocate. Multinational banks do not implicitly differ from the manufacturing firms, therefore theories derived from manufacturing MNEs are likely to be applied to explain banking internationalization. Existing research of multinational banking focuses on developed countries (Goldberg and Saunders, 1980; Goldberg and Johnson, 1990; Fuentelsaz et al., 2002), little light has been shed on developing countries. The market entry and development of foreign banks in China is a phenomenon that demands greater attention from both academics and practitioners as China’s economic status further strengthens. It is believed that the banking sector in China provides grounds for generalizing the identified results to other financial service institutes. Firstly, banking is an important sub-sector of the services industry and shares most of the service features in general. Secondly, the banking sector has been used in prior studies to analyze trends in the financial service industry. The mainstream international business literature focuses on the analysis of the nature of the banking industry. Finally, the opening up of the regulatory environment in China makes it attractive for financial institutions to invest. Hence, the findings we propose on internationalization drivers, evolutionary entry strategies and competitive


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advantages provide practitioners of financial service firms with relevant information and recommendations about future strategies. The rest of the paper is structured as follows. The next section discusses the adopted research methods. China’s banking regulations under the WTO rules and the current local market segmentations are discussed in the third section. The paper then examines the major market entry trends and characteristics of foreign banking activities in China. This leads to implications for banks and policy makers. We end with conclusions. Research methods Differing from existing literature, this study adopted a multi-method research approach that combined both aggregate level data and firm level data. There exists a gap between static model of multinational banking and dynamic elements of banking strategy. Purely aggregate data are not sufficient in studying banking internationalization. The growth of the bank is largely determined by the internal resources of the bank such as reputation, experience, innovations, managerial ability and technological know-how. How banks cope with external knowledge, manage knowledge transfer and apply new knowledge to commercial end is the key to banking innovation and adaptation (Amit and Schoemaker, 1993; Anderson and Kheam, 1998; Foss and Eriksen, 1995). At business strategy level, this relies on the management’s perceptions of the bank’s competitive advantages. Firm level data were collected via self-administered surveys and semi-structured interviews. Banks operating with different modes (i.e. representative offices, wholly-owned branches and subsidiaries) and focusing on different business scopes (foreign currency business and RMB business) were interviewed for pilot testing. We then developed a postal questionnaire based on six identified strategic orientations and 15 refined competitive methods. All questions were answered on a five point scale (1 ¼ least important; 5 ¼ most important). The finalized questionnaire was posted to the senior managers of all the 178 foreign banks in mainland China based on the particulars provided by the central bank. A total of 62 responses were returned. The response rate was 17.7 per cent. Compared with the population, the responses exhibited a good representation of foreign banks in China. Representation of the sample was assured via the calculation of the proportion of banking activities and current entry strategies to that of the statistics of the central bank database. Furthermore, we conducted 37 interviews with foreign bank managers in China. Interview data were analyzed using NUD *IST software. We used the findings of the qualitative data to support the internal and external factors that drive banks’ entry strategy. Such a multi-methods research strategy followed Miles and Huberman’s (1994) research guidelines. Questionnaire and interview data allow us for triangulations. We can be confident of the robust and reliable nature of our results. Regulations and market segmentations China’s WTO accession presents a great opportunity for foreign banks to expand. About 178 foreign banks were authorized to establish 163 branches, 223 representative offices, eight wholly owned subsidiaries and five joint ventures in China by the end of 2005. The number of branches and subsidiaries of foreign banks increased to 254 by the end of 2006. The total assets of foreign banks in China experienced a steady growth over

the last two decades and reached US$171.463 billion at the end of 2007. A total of 154 foreign banks have received license to conduct RMB business across 25 Chinese cities. A total of 25 foreign financial institutions have acquired minority equity control of 20 domestic Chinese banks (China Financial Stability Report, 2006) by the end of 2005. Full market liberalization since 2007 certainly brings far-reaching implications to foreign banks. A number of banks such as HSBC, Standard Chartered, Citibank and Bank of East Asia have been fully prepared to engage in consumer RMB banking services. Together, they have established over 100 retail outlets across major cities in China. However, during the initial five years of China’s WTO accession, the PBOC (The people’s Bank of China central bank) tightly controlled the business scope, type and currency of products and services, operational volume, customer base, number of branches and location of foreign bank operations. The main barriers are likely to be the minimum two-year operation in China (three years for conducting RMB business) prior to formation and the one-year mandatory waiting period for establishing additional branches. What is inconsistent with international practice is that the introduction of new products within a foreign bank’s authorized scope of business requires the PBOC’s prior approval. The latest regulation released by the end of 2006 states that foreign banks must receive independent Chinese legal person status in order to conduct RMB business to Chinese individual customers. This requires foreign entrants to inject more registration capital. There are many other invisible ways for the government to affect the pace of foreign banks’ penetration such as encouraging large state owned enterprises to use domestic banks, setting obstacles to the use of domestic networks by foreign banks, and complicating and prolonging the procedures for approving specific business of specific foreign banks. China’s “big four” state owned commercial banks still dominate the local banking market. They accounted for over 51.3 per cent of the local banking assets, loans and deposits at the end of 2006. In contrast foreign banks only accounted for about 2.4 per cent of China’s banking assets (PBOC Quarterly Statistical Bulletin, 2002-2008). Foreign banks are unevenly distributed by region. Foreign bank branching activities cluster in special economic zones (SEZs), open cities in coastal area and several authorized cities. Beijing and Shanghai are two most preferred locations given their political importance, healthy business environment and efficient government services. Foreign banks also target the inner regions as the second step long-term business expansion once they establish their footholds in SEZs and financial centres. For instance, Standard Chartered Bank initiated a project to provide loans of small amount to cotton peasants from Xinjiang Autonomous Region. HSBC opened its presence in rural areas of Hubei province and Chongqing municipality city to provide loans for peasants and township enterprises. Foreign banks have a competitive edge in both retail and corporate banking in the areas of financial soundness, risk management and financial innovation which constitute the key ownership advantages. However, the Chinese banks are catching up quickly in recent years, particularly in traditional banking market (mainly interest-based business). This intensifies local market competition. Market entry trend and characteristics Motives Foreign banks exhibit a mix of motives including both market seeking and following the client and other motives of which driven by competition, being the first mover,


31

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geographical diversification and cultural connection are the most important. Banks often simultaneously combine several strategic motives and the dominance of these motives may switch over time with the accumulation of local client base and market knowledge. Entry motives vary across different business segments. Market-seeking motive is still the dominant strategic orientation in market entry decisions across the whole banking business segments. Investment banks and retail banks are purely driven by seeking local market development. For corporate banks, following the clients is still important. Many foreign banks consider following the clients as a emergent strategy during the initial entry. The amount and quality of source country FDI strongly influences a bank’s decision to open branch. For trade-related banking business, there can be both aggressive and conservative motives behind. Mode of control Organic growth remains the most attractive option of foreign banks to increase their market presence in China. As some bank managers commented, “wholly owned mode is more preferable if the parent bank wants to transfer its know-how to the overseas offices safely and at a lower cost.” Establishing multiple branches is critical for serving corporate clients and for local retail banking. The best practice to explore local market and establish brand awareness is via branch banking which is still the cornerstone of banking strategy. Equity acquisition in local commercial banks is the second-best option. For universal banks, organic development is no longer sufficient to satisfy the needs for growth. M&As features the recent trend of foreign banking in China. Equity acquisition allows foreign banks to gain access to local strategic assets such as network and client base. Evidence is prominent in retail services where foreign and domestic banks are issuing co-branded credit cards. The local governments normally hand pick foreign banks for strategic alliance based on their financial strength, reputation, track record, technology platform and risk control, and sometimes political connections. The development of foreign banks in China has realized a stable transition from “branch-dominance” to “corporate-dominance” in recent years. It is known that by the end of 2007, CBRC has approved 21 foreign banks to reorganize their Chinese branches as foreign corporate banks, 17 of which had finished the process and run business. By the end of May 2008, about eight banks including HSBC and Citibank have established local entities with most headquartered in Shanghai. A few more like JPMorgan have applied for the same. Not all banks deciding to register as a local entity are aiming at retail business. The impact of local incorporation would have far-reaching implications particularly in areas of capital requirements, supervision, transparency and product opportunities. A joint venture with a local financial institution is only useful as an investment to profit from local growth because full decision power will not be obtained with only 20 per cent ownership. It is difficult to cooperate with a Chinese bank without full control through equity because there is a risk of losing bargaining power and diluting competitive advantages after the transfer of IT systems and other critical capabilities. Outsourcing is also evident in local banking strategy. Foreign entrants capitalize on their specialized core business areas while outsource functions that do not add much value to their overall development strategy. By doing so, foreign banks can improve operational efficiency and reduce risks. Domestic Chinese banks can facilitate foreign

banks’ daily communication with local regulators and act as liaisons to smooth business transactions. In recent years, outsourcing has expanded from front-end office functions to back-end office functions. It mirrors that the cooperation between foreign and domestic banks deepens. Even for most professional and technologically advanced universal banks, improvement in efficiency via outsourcing makes a lot of sense in their product innovation and risk diversification.


33 Strategic choices Based on our empirical findings, we develop an evolutionary framework of development strategies of foreign banks in China (Figure 1). The framework exhibits three main strategic options: client leadership, product leadership and multi-objective strategy. Client- and product-leadership strategies are interrelated. The difference lies in the allocation of core banking resources and strategic objectives that banks pursue. Banks may perceive external environment differently and may possess different bundles of internal resources, hence they may choose to adopt one strategic option over the other. In pursuit of client-leadership, foreign banks focus on maintaining their key existing clients by introducing sophisticated client portfolio management. Client base diversifies with the development of the local market. In order to avoid direct competition with domestic banks, foreign banks tend to target niche market or neglected client segments such as rural market and small to medium sized local private enterprises. Although diversification of client base takes place gradually, a trend can be observed that local corporate clients are taking over FIEs in terms of revenue contributions. For specialized retailing banks, they are seeking aggressive local market expansion by establishing locally incorporated subsidiaries and nation-wide retailing outlets. Product leadership/ Marketing and distribution

U

N

C

High Low

Competitiveness

P

= A necessary move by will or forced by competition

? Low High Competitiveness Market exit

Client leadership/ Marketing and distribution

Figure 1. Strategic choices of foreign banks in China

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In pursuit of product-leadership, product innovation and a restructure in product portfolio appear to be the only sensible solution. Traditional interest-based banking products lack of differentiation. Any new change can be easily copied by domestic banks in a short period of time. Static foreign exchange rate and interest rate also squeeze the profit margin in traditional commercial banking business. Foreign banks need to shift product focus from traditionally interest-based services to high-order fee-based banking products. Product innovation does not merely refer to introduction of new products. It can also mean a modification of existing matured products, innovative solutions in sales and marketing, and improvement in efficiency. In practice, it means that banks may need to market their products in an innovative way. Adjustments involve not only product concept but also technological platform at the back-end office in order to comply with local market regulations. For both client- and product-leadership strategies, location, distribution network, understanding of the local market and proper technological platform to facilitate efficient internal coordination are critical. Universal banks (U), particularly those specializing in retailing business, tend to achieve synergistic leaderships in both client and product by establishing multiple branches and concentrating on product innovation. A good organizational learning culture contributes to more efficient exploitation of external knowledge, client management, product innovation and creative marketing. In contrast, banks that are unable to improve their competitiveness in neither products nor clients would eventually maintain the position N or exit the market. Owing to the difference in bank-specific attributes, banks adopt various tactics. Most of the banks do not have the strength to achieve both economies of scale and economies of scope. They may focus on one strategy at a specific time and move to the other strategy at another time. In this dynamic framework, banks may pursue different strategic focuses over time and their paces of development vary greatly due to the heterogeneity of bank-specific attributes. There is no “one size fits all” strategic approach to the market entry of foreign banks. Market expansion develops incrementally and strategies need to be understood and implemented under the notion of dynamism and pragmatism. Determining factors and competitive advantages Table I exhibits the logistical regressions results for scale. Market development is dependent upon the firm-specific advantages that a bank possesses. In order to increase the local market commitment/penetration in China, foreign banks need to be competitive in following firm-specific attributes: product innovation, ability to develop key clients, ability to adapt technology to the local standard, ability to attract and recruit local expertise, ability to meet the latent demand of the Chinese banking market and cultural proximity. Meanwhile, foreign banks need to have a persistent long-term strategy in China. Many of these attributes are central to the adaptation process in China. For instance, foreign banks with excellent learning culture usually can more efficiently deliver innovative financial products that are compatible with local market regulations and demand. Banks from Hong Kong and South East Asia appear to be advantageous because of their cultural and language proximity. They demonstrate a faster pace of local market penetration.

1. Product innovation 2. Local client resources 3. Technological adaptation 4. Local human capital 5. Persistent Chinese-market-related corporate policy 6. Location choice (geographical presence and distribution) 7. Cultural proximity 8. Ability to meet the latent demand of the Chinese banking market Host country-specific factors 1. Policies and regulations of Chinese banking market 2. The general stability of China 3. Local credit culture Motive for diversification of markets 1. Local market seeking 2. Maturity of a bank’s home market 3. Following the competitors 4. International risk diversification Bank size-related factors 1. Size of the parent bank in total assets 2. Support from the parent bank Operating cost and early entry 1. Early entry to the Chinese market 2. Local operating costs Following-the-clients motivation 1. Following the direct investment 2. Following the trade flows

(Scale 1 ¼ 0) (Scale 1 ¼ 1) Firm-specific factors

1.081 20.041

0.069 * * * 0.286

0.520

0.249 20.860

0.280

0.283 20.306

0.367 20.712

0.531

0.275 20.173

1.241

0.090

0.023 * * 0.294

0.665

0.698 20.394

0.586

0.279

0.152

0.623 2.310 1.743

20.556 0.841 0.444

0.301 0.375 0.331

0.912 0.000 0.001 *

Sig.

0.033 1.575 1.094

Std. error

Notes: Significance at the *0.01, * *0.05, * * *0.1 levels. The reference category is: 2. Model fitting information: x 2 ¼ 22.344, df ¼ 6, Sig. ¼ 0.001. Scale – the degree of local market commitment of foreign banks in China (i.e. establishment of multi-branch network in China). Scale is an ordered variable measured by number of local staff (Fisher and Molyneux, 1996). All variables were grouped using factor loading techniques, which reduced multicollinearity problem

Location

Threshold

Coefficient

95 per cent confidence interval Lower bound Upper bound


35

Table I. Ordered logit model for scale

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How can banks adapt into the local market by minimizing their risk exposure without losing opportunities for growth? The answer to the question very much relies on how banks cope with external knowledge and maximally exploit their competitive advantages accordingly in the foreign market. Both qualitative and quantitative analyses show that bank size and client resources are obvious factors that affect the growth of foreign banks in China. Bigger banks not only enjoy the advantage of diversity but also have much more scope to sell off assets in times of trouble. In theory they should be better in credit analysis too because they have more data to comb through and more opportunity to spread the cost of investment in things like IT system. The benefits of scale and diversification are much more apparent when the going is tough. Universal banks can diversify risk more easily than smaller-sized specialized banks and find themselves open to more options in terms of entry route choices. Banks tend to develop faster by relying on and extending their existing client networks in China. For market-seeking banks, the capability to cultivate a sound local business environment and develop local clients lies in the centre of sustainable long-term growth. Differentiation of banking services very much depends on innovation in client management and product services. Individualized services, price-competitive products and delicate care of client relationships determine whether a bank can retain old clients, continuously engage in new client relations and deliver new products to the end-users more efficiently and effectively than its competitors. Banking services are highly leveraged. A small difference even an improvement in efficiency would lead to differentiation, which in turn can cause barrier of entry for other market players. We further identify that organizational learning and internal coordination, quality of managerial resources and cultural proximity are vital in dictating and differentiating the development pattern of foreign banks. Each factor turns out to feature different development stages and their roles in affecting the degree and timing of local market expansion vary. How banks cope with external knowledge and being innovative in creating new knowledge for sustainable growth is an essential element in shaping developing strategies. High quality managerial resources facilitate knowledge transfer and the creation of new knowledge. The effectiveness in knowledge absorption and generation is the key to banking innovation and adaptation. Better training and a pool of qualified managerial staff also ensure a good communication internally and with clients or regulators. Ultimately this can enhance performance and speed up the pace of expansion. Cultural closeness is an uncopiable advantage that offers banks quicker access to the local market. An in-depth understanding based on similar cultural background and a common language facilitates business innovation and adaptation in the post-entry development. Implications In total, 80 per cent of our surveyed banks indicate that profit has been growing above 40 per cent in the last two years. The optimism of foreign banks is evident. The business of foreign banks operating in China is booming and will continue to expand with a growing Chinese middle class, soaring foreign investment and the opening up of the regulatory environment. But surely there are lessons to learn from the past experience.

Implications for foreign banks Foreign banks that capitalize on specific opportunities and market growth in China need to be very clear about their corporate objectives. Based on our research findings, only a handful of foreign banks have a clear and genuine long-term strategy for China. Cultural issues and understanding of the corporate and private customer are vital in constructing banking strategy. Such knowledge can only be acquired and developed through an incremental learning-by-doing process. There is no alternative route to skip this learning stage. Foreign banks who want to catch up in the race of local market expansion will have to make a concerted effort over the medium to long-term to build their infrastructure base including networks, client resources and human assets. Any attempt to confront a face-to-face competition with Chinese banks would come with extremely high cost and sometimes would lead to the failure of the whole business plan. In order to succeed in China in the long run, foreign banks will need Chinese banks to be successful in their restructuring programmes so that the market as a whole develops and matures. Therefore, improving the competitiveness of the Chinese banking industry as a whole will bring a win-win outcome that both Chinese and foreign banks can have a share of a bigger market. The recent US sub-prime crisis raises particular skepticism about whether large western banks or their regulators truly understand the risks associated with derivative on their balance sheets. Attitudes towards foreign financial institutions are hardening publicly in China. Liu Mingkang, Chairman of the CBRC, indicates that China is likely to open up to international banks even more slowly than it has already. The market has ringed bells for foreign banks to implement more careful and smarter risk management strategy. The fact has shown how hard it is to quantify risk in a less transparent market. Credit analysis remains critical to the functioning of the financial system. No other institutions have the infrastructure, the people, the data and the reputations that the banks can call on to carry out that task. However, “know your customer” is staple of banking that has largely been forgotten because of the disaggregation of the supply chain. There is now likely to be more emphasis on non-statistical ways of thinking about risk. That means being more rigorous about imagining what could go wrong and thinking through the effects. Intensified local competition has pointed to the value of having stickier retail deposits, especially now that wholesale funding costs have rocketed. Even if foreign banks are successful in bringing new money in, two deeper questions remain. The first is whether the new money will stay. Banks need to deliberately target less rate-sensitive customers or offer high-yielding products. The second question is how much money banks can make if they have to compete so hard to entice savers. There are ways to offset the higher costs of deposits, for example the structured accounts where the payouts are linked to the performance of equity indices and where risks can be hedged, but such products are definitely not for mass market and limited by local market regulations. Implications for Chinese banks From the perspective of Chinese banks, they had a five year “grace period” to gear up to finally meet the global competition. Apart from the continuous handling of NPLs, Chinese banks will have a lot more to do to shape their competitive strength and maintain their existing market shares.


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Public listing is only one of the means to mitigate the pressure caused by previous wrong lending decisions and push local banks toward real commercialization. More effort needs to be made internally. This includes the improvement of corporate governance, credit and risk management, product innovation, marketing, security and human resources management. A greater emphasis on capital and liquidity will have consequences for the business models of many local banks. Adjustment in risk management strategy also means more selective lending in order to keep asset growth under control. There is plenty of scope to improve performance with operational changes. This signals more rights issues and in some cases it also means M&As activity. Banks with lots of capital are in a stronger position to deploy it but will be very careful with their due diligence. Medium and smaller-sized Chinese banks should take a more domestic approach to focus on their existing markets. Their advantages are that they are less burdened than state-owned banks and more flexible and efficient in adopting new technologies and marketing skills. It enables them to identify neglected market niches and make quick responses. Sometimes teaming up with multinational players can offer them a big leap forward. However, potential partners need to be carefully chosen. For equity alliance, Chinese banks need to pay extra attention to the establishment of common interests and reduction of threat of becoming potential competitors. They also need to build up compatible management practices and maximally explore complementarities possessed by both partners while not risk losing bargaining power and diluting competitive advantages. In terms of risk control, Chinese banks need to learn credit analysis techniques from western banks. Western banks normally issue non-collateral lending based on their credit analysis and they can still keep a balance between their risk and returns. In contrast, Chinese banks normally are only willing to issue collateral lending but still they encounter huge NPLs. Western banks adopt a mature system for portfolio management so that they can reduce or hedge risks effectively. How to best allocate banking assets and keep a minimum risk is the core to Chinese banking reforms. For state-owned banks, the challenge is how to pass on good experience and best practices throughout their hulking organizations. Implications for policy makers Banking industry always has the highest government intervention. The liberalization pace of the Chinese banking and financial market is much faster than that of Japan and the USA. Drawn from experiences, regulators need to pay extra attention to the following areas. The first is to take a broader view of risk. That means looking at off-balance-sheet assets and at gross exposures. The entry of foreign banks certainly brings new challenges to the Chinese regulators. One of the challenges lies in the treatment of innovative products. New products such as securitization widen access to capital for borrowers and to assets for investors. Leverage brings more lazy companies within reach of determined investors. New products do not just lack the historic data that feed models. They often also sit outside banks’ central risk management machinery, being run by people on individual spreadsheets until demands for them is proven. Modern financial systems contain a mass of amplifiers that multiply the impact of both losses and gains, creating huge uncertainty. That makes it impossible to get an accurate picture of aggregate risk even if individual risks are being managed well.

As one regulator from the central bank notes, “we have all the sheep in the sheepfold but not the sheepfold”. Risk management will concentrate much more on the size of banks’ absolute exposures. The quality of risk management at individual institutions does not necessarily provide enough information about the overall stability of the system. Many believe that private equity firms are about to begin making their presence felt in China. This will obviously increase the leverages in the Chinese financial market and further complicate the regulatory framework. Second, regulators need to push banks to build buffers when times are good so they have stronger defenses when times are bad. This requires banks to increase the amount of capital and liquidity that banks set aside when risks are building, and reducing the amount of leverage they can take on. Risk is rarely understood until after the fact. Banks may actually run higher risks in order to compensate for the effects of tougher capital requirements. Third, world economic downturn and rise of inflation are issues that Chinese regulators and decision makers urgently need to tackle with in order to increase vitality of domestic financial market and maintain the stability of macro economy. China’s true inflation rate may be higher because the consumer-price index does not properly cover private services. China may need to allow more flexibility in their exchange rates. The revaluation may also encourage investors to expect further appreciation, which may attract more inflows of speculative money and so exacerbate inflation. A state-driven financial market means state firms tend to do best. Financing for start-ups remains largely informal, which stifles entrepreneurship. Chinese citizens try to put away money for retirement, for their children’s education or other personal needs. They are given a bleak choice of subsidizing the financial system through deposits yielding less than inflation or speculating on highly volatile shares. Stimulating domestic demand is correct on the one hand, reforming financial markets is inevitable. Fourth, entry of foreign banks urges reforms in China’s governing and legal systems. Frictions increase while foreign banks deepen their local market penetration in the last several years. Banks operating in different jurisdictions need time to adapt their banking practices into the new market. Problems also arise from China’s complex governing structure. Cross-selling strategy currently adopted by foreign banks obviously introduces new challenges to the governance of financial services. There have not been any rules or regulations specifically relating to such complicated financial service packages. In addition, it is very often the case that rules erected by different governing bodies clash with one another or at least not consistent. The complication in governing structure reduces the transparency and efficiency in governance. It further leaves many unexplained “gray areas” for financial practices that both regulators and business practitioners find difficult to cope with. Conclusions The Chinese banking system clearly needs reform in terms of the introduction of innovative foreign practices. However, policy makers also need to bear in mind the stability of the financial system and the balance between prudence and market liberalizations. Foreign entrants have been learning how to cope with the dynamic local environments. This study traces these developments. The empirical findings show major trends and characteristics of foreign banking in Mainland. The paper offers important insight and implications to the understanding of multinational banking in emerging markets.


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References Amit, R. and Schoemaker, P.J.H. (1993), “Strategic assets and organizational rent”, Strategic Management Journal, Vol. 14, pp. 33-46. Anderson, O. and Kheam, L.S. (1998), “Resource-based theory and international growth strategies: an exploratory study”, International Business Review, Vol. 7 No. 2, pp. 163-84. China Financial Stability Report (2006), China Financial Stability Report, PBOC Press, Beijing. Fisher, A. and Molyneux, P. (1996), “A note on the determinants of foreign bank activity in London between 1980 and 1989”, Applied Financial Economics, Vol. 6, pp. 271-7. Foss, N. and Eriksen, B. (1995), “Competitive advantage and industry capabilities”, in Montgomery, C.A. (Ed.), Resource-based and Evolutionary Theories of the Firm, Kluwer Academic Publisher, Dordrecht. Fuentelsaz, L., Gomez, J. and Polo, Y. (2002), “Followers’ entry timing: evidence from the Spanish banking sector after deregulation”, Strategic Management Journal, Vol. 23 No. 3, pp. 245-64. Goldberg, L.G. and Johnson, D. (1990), “The determinants of US banking activity abroad”, Journal of International Money and Finance, Vol. 9 No. 2, pp. 123-37. Goldberg, L.G. and Saunders, A. (1980), “The causes of US bank expansion overseas: the case of Great Britain”, Journal of Money, Credit and Banking, Vol. 12 No. 4, pp. 630-43. Miles, M. and Huberman, M. (1994), Qualitative Data Analysis: An Expanded Sourcebook, Sage, Beverley Hills, CA. PBOC Quarterly Statistical Bulletin (2002-2008), PBOC Quarterly Statistical Bulletin, PBOC Press, Beijing. Further reading Anderson, E. and Gatignon, H. (1986), “Modes of foreign entry: a transaction costs analysis and propositions”, Journal of International Business Studies, Vol. 17 No. 3, pp. 1-26. Corresponding author Chen Meng can be contacted at: [email protected]



An overview and assessment of the reform of the non-tradable shares of Chinese state-owned enterprise A-share issuers

Reform of the non-tradable shares 41

Paul B. McGuinness Department of Finance, The Business Administration Faculty, The Chinese University of Hong Kong, Shatin, Hong Kong Abstract Purpose – The purpose of this paper is to provide an updated and critical assessment of the share reforms relevant to Chinese A-share issuers listed in the two mainland markets of Shanghai and Shenzhen. The reform programme first began in 2005 and has now spread widely across issuers in the two markets. It is therefore timely to assess how effective the reforms have been as well as gauging the ongoing effects of the transformation (of non-tradable scrip into tradable form) on A-share prices. Design/methodology/approach – The “Split Share Structure” reform programme represents a major policy initiative in China and potentially opens-the-door to large-scale state-share disposals. The evidence to date however suggests that the Chinese authorities are primarily concerned with the reconfiguration of the array of share types that presently exist into a more comprehendible, streamlined form. The various checks and balances imposed on controlling shareholders engaged in the transformation of their shares from non-tradable to tradable form suggest that eventual re-designation of the holdings into an unfettered tradable type will not necessarily translate to the state’s acquiescence in the disposal of such shares. On the contrary, state holdings in the most strategic of assets are likely to be retained more or less intact. Insights are developed by focusing on examples involving major A-share issuers. In particular, a case study of the Sinopec reform proposal of August/September 2006 is set out to help illuminate the principal features of the reform package. Critical examination of the empirical literature relating to the A-share price effects of the share reform programme also features. Findings – There is little evidence to date of significant stock disposals amongst the largest and most strategic of China’s issuers. However, for a number of A-listed issuers, parts of the lock-up moratoria have already expired or are set to do so in the very near future. Given the precipitous fall in A-share prices (in Shanghai and Shenzhen) since late 2007, largely wrought by the enveloping global credit-crunch, the Chinese authorities have an even more compelling case than hitherto to assiduously dampen fears of large-scale state-share disposals. Notwithstanding this, at least a small part of the drop in A-share values during 2008 derives from the building risk-premium on this issue. Research limitations/implications – As the trading moratoria on re-designated shares still applies in most cases, at least in respect of the majority of domestic stock holdings, a clearer picture will not emerge until 2009-2011 when all such moratoria would have lapsed. Originality/value – The discussions in this paper help to bring into focus a highly topical issue within the context of the Chinese equity market. Keywords China, Shareholders, Shares, Shareholder value analysis, Government policy Paper type General review

The author would like to acknowledge comments from the Guest Editor, for this Special Issue of The Journal of Financial Regulation and Compliance, Dr Charlie Cai, for his valuable comments on an earlier draft of this paper.


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1. Background This paper provides an assessment of China’s “Split Share Structure” Reform (CSRC, 2005) programme which first began in 2005 and has now spread across virtually all issuers on its two constituent mainland markets: Shanghai and Shenzhen. The reform specifically serves to re-designate non-tradable stock, in mainland PRC-incorporated issuers that already have established A-share listings, into tradable (A-share) form. At the time of writing, this transformation process is only part-way through given that most of the non-tradable stock is now “tradable subject to trading restriction”. The passing of the various moratoria or “lock-up” dates on this newly designated stock will mark the complete metamorphosis of the originally non-tradable stock into a tradable form completely unfettered by trading restriction. While brief comment on the transformation process has already featured in this journal (McGuinness, 2006, pp. 42-3), the time is ripe for a further look at the reforms, especially as certain parts of the trading moratoria imposed on such re-configured “restricted” shares have in many cases just lapsed or are about to do so. As argued at the outset, this transformation is a creeping or gradual one, but eventually will entail a huge increase in the supply of tradable A-stock, as the newly converted stock complements pre-existing tradable A-share floats. The burning question is what impact will such an increase in tradable float size have on A-share valuations? To some extent, Chinese A-prices have already impounded the anticipated effect. However, as shall be argued later in this paper, a building risk premium or dampening effect is apparent in a number of issuers where lock-up expiry looms. The nature of such trading moratoria, and the various ways in which the regulatory powers and controlling shareholders have tried to lessen the building risk premium are central considerations in the whole share reform programme, and are critically assessed in the second-half of this paper. Before focusing the spotlight on this issue, a brief discussion of the nature of the “Split Share Structure” besetting mainland-PRC incorporated issuers follows in Section 2. This entails comparison of the two principal stock types: domestic non-tradable stock (the subject of the re-designation exercise) and domestic tradable A-stock. Section 3 then sets out the key characteristics of the share reform programme. Specifically, the nature of the proposals, and the associated compensation and voting privileges extended to existing tradable A-share investors are scrutinized and illuminated within the context of a detailed case study. In Section 4, attention focuses on a minority of SOEs that are able to issue tradable shares not just in A-share form but also in B- (or H-) share form. While in the vast majority of cases mainland PRC-incorporated issuers only have recourse to tradable A-shares, a select group of very large and strategic issuers have been meted-out for concurrent A- and H-share listings. Comment on this special group of issuers is essential, especially in relation to the ongoing share reform issue. Assessment of recently disclosed provisions on the permissible methods of share disposal, and the associated disclosure requirements, for stock transformed from domestic, non-tradable form into tradable A-share form then features in Section 5. Conclusions logically follow in Section 6. 2. The “Split Share Structure” of A-listed mainland PRC-incorporated SOEs: the non-tradable/tradable stock dichotomy Domestic Chinese mainland shareholders afforded the privilege of share conversion under the CSRC’s (2005) “Split Share Structure” reform typically constitute state-related

concerns, and hail from the regulatory, governmental or corporate-spheres. Such state parties are sometimes joined by domestic “legal-person” shareowners and, occasionally, employee-based stock owners. In the vast majority of cases, state-related parties dominate within the domestic non-tradable stock component. Moreover, domestic, non-tradable stock accounts for more than 65 per cent of stock outstanding across the 1,500 or more listed A-share issuers (on the Shanghai and Shenzhen exchanges). Reference to the “China Stock Markets Web” facility at Hong Kong Exchanges and Clearing Limited (www.hkex.com.hk/) reveals that as of 24 October 2008, the tradable A-share market capitalization of Shanghai and Shenzhen combined was RMB 3,994 billions, as compared to a total market capitalization figure for the two markets of RMB 11,874 billions. The latter is computed by imputing value to domestic, non-tradable stock in a given entity using the secondary market price for its tradable A-stock. By way of example, suppose an entity ABC has 3,000 million tradable A-shares with market price RMB 5 and 7,000 million domestic, non-tradable shares. The market capitalization imputed to the non-tradable stock would be RMB 35,000 million, suggesting a total market cap for the entity, comprising the market cap of the negotiable component plus the value imputed to non-negotiable component, of RMB 50,000 million. Leaving aside the issue of whether such an imputation exercise makes good economic sense or not, one can see that across the whole market the ratio of non-tradable stock to tradable A-stock is of the order 2 to 1 (or, more precisely, 66.36 to 33.64 per cent). It is also important to emphasize that in a given entity like ABC the tradable and non-tradable share components of the “Split Share Structure”, in theory, rank pari passu with one another in terms of voting rights, dividends (given equal par values, typically at a level of RMB 1.00) and capitalization benefits. The only difference is the trading right. The unravelling share reforms will of course eventually remove this final and fundamental area of difference. As virtually all listed A-share issuers have undergone share reform, domestic, non-tradable shares are more aptly described these days as “tradable shares subject to trading restriction”. Such reconfigured shares, as representations of hitherto purely non-tradable domestic shares, are commonly referred to in the media as “Gu Gai” (G-) or “reform” shares (Anderlini, 2005). The G- in this context captures the first letter of the shortened Pinyin form of the term for share reform (Gu Piao Gai Ge) in Putonghua. For shares currently listed in A-form, all trades are conducted in Chinese Yuan for the 1,500 or more listings across the Shanghai and Shenzhen market places. Dual listings of such shares are not apparent, so that issuers on the Shanghai market are separate from those in the Shenzhen market. The Shanghai market accommodates the largest of issuers in terms of market capitalization and, by and large, Shenzhen caters to small-to-medium sized concerns, especially those with a focus on the Pearl River Delta. Owing to a restriction on trading rights, tradable A- stock is only accessible by parties/entities indigenous to the Chinese mainland and thus constitutes domestic tradable scrip, as opposed to foreign tradable stock (B- and H-shares, to be discussed later in this paper[1]). The only foreign party afforded access to China’s tradable A-share market is the Qualified Foreign Institutional Investor (QFII). QFIIs constitute investment entities from Hong Kong, the rest of Asia, North America and Europe, and as shown in Ferguson and McGuinness (2004), have limited investment scope due to constraints imposed in relation to the choice of A-share investment, the investment holding period (or lock-up arrangements) and the earmarked quota for investment.


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To all intents and purposes, then, the tradable A-share market is a market for mainland Chinese (i.e. domestic) investor concerns. Its segmentation from overseas markets can be viewed as an analogue of China’s long-held capital control policies. Parties from Hong Kong, Taiwan, Macao and further afield (i.e. “foreign” parties within the context of mainland China’s equity markets/capital control policies), unless afforded the QFII trading-mantle, can only trade in the B- and H-shares of mainland-incorporated SOEs. B-shares, as traded in US$ in Shanghai and in Hong Kong Dollars in Shenzhen, are something of a side-show these days, given the small number of listings, float size and the moribund IPO market for such listings. H-shares offer the preferred route for many “foreign” investors wishing to trade Chinese SOE shares. In brief, an H-listed stock is one quoted outside mainland China, where virtually all trades take place between non-mainland parties. However, Qualified Domestic Institutional Investors and mainland retail investors, in compliance with the provisions of the 2003 Closer Economic Partnership Agreement between Hong Kong and Beijing (Su et al., 2007), have enjoyed limited access in recent years. In addition, a number of mainland Chinese entities with established foreign exchange reserves can, subject to defined quotas, trade H-shares. The vast majority of such listings are organized in Hong Kong, though a number of US-listed American Depositary Share programmes (Arquette et al., 2008) are issued on major Hong Kong-listed H-counters. Such ADSs are often referred to as “N-shares” and constitute an additional listing of the underlying H-shares, albeit in ADS form. Finally, in assessing the nature of the reform programme, it should be made abundantly clear that while eventual listing of the “G-shares” offers the potential for stock disposal by domestic parties (principally state-related share owners), some level of political ascent would inevitably be required before controlling parties were afforded such a privilege. In many ways, then, the overarching objective of the reform programme is one of simplifying the share structure of China’s mainland-incorporated SOEs, and not of opening-the-door to the wholesale disposal of state-held shares. The essential thrust of the scheme therefore is one of reforming the prevailing “Split Share Structure” (CSRC, 2005) of an A-listed mainland-incorporated issuer into a unified tradable (A-share) form. Removal of the “Split Share Structure” would ultimately push such mainland-incorporated issuers a little closer in the direction of the offshore-incorporated “Red-Chip” counter. The latter, as exemplified by Hong Kong-incorporated issuers China Mobile, CNOOC and China Unicom, in which major state-related shareholders are present, are issuers with 100 per cent of their outstanding stock in tradable form. Even after completion of the “Split Share Structure” reform, mainland-incorporated issuers would still be different to “Red-Chips” in two important respects. First, they would still be subject to different regulatory provisions and, second, their tradable share structure could comprise combinations of A-, B- (or H-shares) rather than the single ordinary share type apparent in the “Red-Chip” issuer. 3. Essential features of the share reform programme The re-designation (of domestic non-tradable stock) into tradable form first began in May 2005 when the China Securities Regulatory Commission (CSRC) announced a Pilot Scheme targeted at four A-share issuers (O’Neill, 2005a). The scheme was duly enlarged to 46 issuers one month later (Tang, 2005), and then extended across more or less the whole A-share market during the second half of 2005-2007. The progression across the market has been such that virtually all established issuers on the Shanghai

and Shenzhen A-share markets have now garnered support for the requisite share reform proposals. The details of the various provisions governing such schemes are as stipulated by the CSRC (CSRC, 2005) and discussed in the following. 3.1 Case study of The China Chemical & Petroleum Corporation (Sinopec) share reform proposal of August/September 2006 To bring the share reform proposal discussion into focus, study of the reconfiguration of China Chemical & Petroleum Corporation’s (Sinopec’s) non-tradable stock component is set out in the following. Sinopec is chosen because it represents one of China’s largest and most strategic of issuers. It has also had share listings in place for some time, with respective H- and A-listings established in 2000 (in Hong Kong) and 2001 (in Shanghai). The August 2006 share reform proposal, as mounted by Sinopec’s domestic stockholders, ultimately required support from tradable A-share investors for it to go forward. To compensate for the possible deleterious effect of such conversions on the market price of pre-existing tradable A-shares – occasioned by the eventual transformation of such stock into unrestricted tradable form – bonus shares were offered to existing tradable A-share investors on the basis of 2.8 consideration shares for every ten already held. The consideration shares in this context were shares offered from existing domestic, non-tradable holdings with arrangement made for their immediate conversion into tradable A-share form upon completion and acceptance of the share reform proposal. 3.1.1 Provisions governing the form of the Sinopec reform proposal. As set out in Article 5 of the CSRC’s pronouncement on the subject, a proposal can only get off the ground if at least two-third of the votes of the domestic (i.e. non-tradable) shareholdings are mobilized in favour. Specifically, Article 5 states inter alia that: All non-tradable shareholders of a listed company shall in principle reach a consensus before they propose a motion on the split share structure reform. In case of a consensus cannot be accomplished, such motion may be proposed by a shareholder/shareholders holding individually/collectively two-thirds of the non-tradable shares of the listed company [. . .] [CSRC (2005, Article 5, First Para)].

Once a proposal is air-borne so to speak, it has to be then carried by a two-third majority amongst the voting tradable A-share investors. Article 16 sets out the provisions on this matter: The reform plan of a listed company shall be approved by shareholders with at least two-thirds of voting shares at the relevant shareholders’ meeting. Such reform plan shall also be approved by the tradable shareholders owning at least two-thirds of tradable voting shares at the relevant shareholders’ meeting [CSRC (2005, Article 16)].

Lee (2008, pp. 70-2) offers a critical assessment of the various voting provisions and notes, amongst other things, that tradable A-share investors may not necessarily be in a strong position to evaluate the “fairness” (p. 70) of the compensation offer. Leaving such considerations aside, both sets of Sinopec’s shareholders, domestic and non-tradable – in relation to Articles 5 and 16 in the CSRC (2005) stipulations – lent strong support to the reform proposal (Sinopec, 2006e). Essentially, Sinopec’s reform proposal saw an almost immediate transformation of its pre-existing share structure (see Table I, part (a) and the reconfigured one in


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Table I, part (b)). Acceptance of the proposal had no effect on the total number of shares outstanding, nor on the number of H-shares outstanding. However, the tradable A-share pool was enlarged by 28 per cent, in accordance with the 2.8 for ten bonus issue. The number of tradable A-shares thus rose from 2.800 billion to 3.584 billion shares, with the 0.784 billion share increase obtained through the transfer and conversion of 777,147,000 shares from the sole domestic state-related share owner, “China Petroleum Corporation”, and the remaining 6,853,000 shares from the single legal-person share owner, “Guotai Junan Securities” (Sinopec, 2006f, p. 3). The relative consideration paid by each of the two domestic shareowners in Sinopec was determined in proportion to their pre-proposal holdings. As noted in Fang et al. (2008, pp. 25-6), share reform proposals typically result in two-periods of trading suspension for the underlying issuer. As reflected in data extracted from Datastream, Sinopec’s tradable A-shares (code 600028) were suspended from trading on the Shanghai Stock Exchange for a period running from Monday, 21 August 2008 to Wednesday, 6 September 2006 (13 trading days) and between Friday, 15 September and 9 October 2006 (17 trading days). The first suspension was triggered following the initial reform announcement (Sinopec, 2006a) and came to a close shortly after the confirmation of the terms of the reform proposal (Sinopec, 2006c). With regard to the latter: After publication of the share reform scheme [. . .] directors assisted the communication between the holders of non-tradable shares and investors through visits, holding of investors’ seminars, conducting internet road-shows and establishing hotlines, etc. Based on these results [. . .] the share reform scheme of the Company shall remain unchanged (China Petroleum & Chemical Corporation (Sinopec), 2006, p. 1. Capitals shown as used).

The second suspension was ushered-in by a notice (Sinopec, 2006d) informing shareholders that voting registration would commence 15 September 2006. A subsequent announcement (Sinopec, 2006f) on the reform’s implementation, Number of shares outstanding Percentage of outstanding shares (a) Share structure of Sinopec immediately prior to the reform proposala Non-circulating Shares Domestic shares 66,535,191,000 76.74 State-owned legal person shares 586,760,000 0.68 Listed and circulating shares A Shares 2,800,000,000 3.23 H Shares 16,780,488,000 19.35 Aggregate number of shares 86,702,439,000 100.00 (b) Share structure of Sinopec immediately following reform proposal approvala Circulating A shares with lock-up Domestic shares 65,758,044,000 75.84 State-owned legal person shares 579,907,000 0.67 Circulating shares without lock-up A shares 3,584,000,000 4.13 H shares 16,780,488,000 19.35 Aggregate number of shares 86,702,439,000 100.00

Table I.

Note: aFigures and categories extracted verbatim (in quotation marks), from “Share Reform Announcement” Source: Sinopec (2006b)

indicated that upon completion of the record period for parties eligible for bonus shares, trading of the pre-existing A-shares and newly converted consideration shares would commence 10 October 2006. One of the most important features of the reform programme concerns the application of trading lock-ups, or trading moratoria, to the newly constituted reform or G-shares. As spelled out in Article 27 of such regulations (CSRC, 2005), the moratoria stretch-out across a 36-month period following reform implementation, with absolute “lock-up” of the reconfigured shares featuring for the first 12 months of this three-year period. Between 12 and 24 months a partial “lock-up” of the G-shares applies, whereby the holder of the reform shares is able to list (and potentially sell-down) a proportion of their shares equivalent in number to 5 per cent of the issuer’s total number outstanding. A further 5 per cent tranche is made available for listing between 24 and 36 months’, after which time CRSC “lock-up” provisions on the reform stock cease, and all remaining G-stock is therefore potentially eligible for listing and/or sale. However, a further layer of approval by the State-owned Assets Supervision Administration Commission may mean that more stringent “lock-up” provisions apply (China Daily, 2007). In addition, a number of domestic controlling shareholders have sought to impose lock-up arrangements on their shares that go well beyond the base requirements set by the CSRC. Yanzhou Coal Company Limited provides such an example. In its reform proposal of 24 January 2006, the sole domestic controlling shareholder, the Yankuang Group, consented to lock-in its shares absolutely for four years. Specifically: [. . .] non-tradable shares held by Yankuang Group will be subject to a trading moratorium of 48 months from the date of the completion of the Share Reform Plan. In the event that Yankuang Group fails to fulfill this undertaking, all monies received from the disposal of any of such shares shall be paid to [. . .] the Company. (Capitals reported as used, “Announcement on the Share Reform Plan by the Company’s Controlling Shareholder, Yankuang Group”, 24 January 2006, available at: www.hkexnews.hk/listedco/listconews/sehk/20060125/ LTN20060125053.pdf).

For the Sinopec case study at hand, the various moratoria (for 12-, 24- and 36-months post-reform) can be discerned from announcements on the subject (specifically, see Sinopec, 2006b, p. 5). For the controlling shareholder, China Petrochemical Corporation, 433,512,200 shares from its immediate post-reform holding of 65,758,044,000 shares were eligible for listing after the one-year anniversary date of the proposal’s implementation. In compliance with Article 27 of the CSRC’s (October 2005) requirements, this constituted exactly 5 per cent in number of Sinopec’s outstanding stock position. After a further 12 months, another 433,512,200 shares would become eligible for listing and after 36-months all of the remaining non-listed holding takes on listing eligibility. Reference to Sinopec’s Annual Report (2007) and Sinopec’s Interim Report (2008, pp. 5-6) make it clear that China Petrochemical Corporation had not disposed of any its 65,758,044,000 shares between the date of the reform’s implementation and late August 2008, the point at which the Interim Report 2008 was disclosed. The effects of the reform set out in Table I also make it clear that H-share holders are excluded from both the compensation and voting arrangements. There is however no dilution in the ownership interest of H-share investors, as the consideration shares paid to tradable A-shareholders represent existing shares and do not, as a consequence, enlarge the issuer’s equity base. The same principle also appears to have been adopted for issuers with concurrent A- and B-share listings, in the sense that B-share investors


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are side-lined from compensation and voting in relation to the share reform schemes (O’Neill, 2005b). Interestingly, Lee (2008, pp. 72-5) considers the general issue of “fairness” in relation to the absence of compensation payments to B-investors. She notes that: [. . .] it may be possible to justify exclusion of B shareholders on the basis of economic expediency, it behoves us to enquire if the discriminatory move can be justified on legal grounds [. . .] It is hard to justify it on the principle of fairness because making non-tradable shares tradable will dilute the value of the companies’ shares and B shares will also lose value (Lee, 2008, p. 74).

Lee’s comments also raise “fairness” concerns with regard to the treatment of H-share issuers, in cases where both A- and H-share listings are in place at the time of reform proposal. 3.2 Market levels of consideration payment made by domestic stockholders to existing tradable A-share investors The 2.8 for 10 bonus (consideration) arrangement in the Sinopec case appears to lie within the “normal” range for such payments. Fang et al. (2008, p. 32), in relation to 234 of the 300 stocks represented in the “Shanghai Shenzhen 3000 Index”, for share reform proposals instituted prior to 1 July 2006, show that the median “distribution proportion” of the various compensation offers lies between 20 and 30 per cent (i.e. between 2 and 3 bonus shares for every ten tradable A-shares held). A total of 61 of the 234 issuers they examined had “distribution proportions” between 0 and 20 per cent and 73 between 30 and 50 per cent. While the terms of such bonus/compensation schemes vary considerably across issuers, the norm is that such (bonus) shares have no impact whatsoever on the issuers’ total number of shares outstanding; instead the consideration shares represent a transfer, and immediate conversion into unfettered tradable form, from controlling parties to tradable A-investors. On this subject, Fei et al. (2008, p. 20) provide details of consideration payment forms for the 208 issuers they investigate. The vast majority simply appear to offer bonus shares from existing controllers, although there are some cases of payments being made using “warrants”, “cash”, “profits” or a “combination” form. Li et al. (2008), in relation to a sample of 1,185 A-listed issuers, all of which had directed share reform proposals to constituent tradable A-share investors prior to the 2007 year-end, report an average “consideration ratio” of around 30 per cent. They also note that the higher the level of state ownership prior to the reforms, the greater the consideration payment to tradable A-share investors, which they interpret, based upon their model of such payments, as testimony of the relative bargaining position of the two sets of players. Specifically, Li et al. (2008) conjecture that the “bargaining power” of a state controlling party weakens the higher its ownership level and, consonant with the increased price distortion emanating from the subsequent conversion of such holdings, requires a greater consideration payment to be made. A related finding in their study is that the consideration payment behaves inversely with the proportion of tradable A-shares outstanding. Two other significant results emerge. First, Li et al. (2008, p. 28) report that consideration payments tend to increase the lower the profitability of the underlying issuer and, second, that such payment ratios have generally fallen over time.

3.3 The announcement effect of the “Split Share Structure” reform proposals on issuers’ underlying A-share prices What about the impact of the various compensation packages on tradable A-share prices? Fei et al. (2008) shed some light on this issue by considering cumulative three-day returns around individual reform proposals for 208 issuers in 2005 and 2006. Their results suggest that on average significant return effects are not evident. This is consistent with tradable A-share investors anticipating the approximate magnitude of the compensation package offered. A study by Feng and Xu (2007), of the first 46 issuers meted out for share reform, in pilot stages one (four issuers) and two (42 issuers) of the scheme in 2005, points to positive significant abnormal return effects. This, as the authors attest, appears to be consistent with the positive effect of the overall reform programme in quelling market uncertainty during the incipient phase of the reform’s introduction (to the overall market). As Fei et al. (2008, p. 11) exclude issuers from the very first stage of the Pilot Scheme and have disproportionately more firms in their study sample from the third batch of entrants onwards, the obvious deduction to be drawn from comparison of results between this and Feng and Xu’s (2007) study, which focuses on the first two batches of entrants, is that as confidence in the share reform programme firmed during late 2005 and through much of 2006, the effects of individual reform proposals on constituent share prices waned somewhat. As an interesting aside, it would be useful to know how the reform announcements have impacted upon share prices of issuers with adjoining B- (or H-) listings. Despite differential pricing between issuers with concurrent A- and B- (Sun and Tong, 2000; McGuinness, 2002; Chan et al., 2008) and A- and H-share listings (Birtch and McGuinness, 2008; Arquette et al., 2008), a priori one would expect some spillover given an adjustment on the associated A-share price. However, due to the trading restrictions on A- and B- (and A- and H-) shares, for given issuers with concurrent listings of such stock types, it is not clear how such spillover effects might play-out. Essentially, such restrictions prevent A- and B- (and A- and H-) shares from being mixed together, such that A-shares must trade separately from B- (and H-shares). Nonetheless, pricing effects on adjoining B- (or H-) shares are likely and should be a function of the timing of the reforms, the consideration terms announced in the share reform proposal and, especially, the trading moratoria imposed upon the reform (G-) share holders. This issue clearly awaits further enquiry[2]. 3.4 The determination of the lock-up arrangements on re-designated shares and their potential impact upon A-share valuations The question of the determination of the period of issuer lock-up (or “lock-in”) is also an interesting one. One might conjecture that, for controlling players locking-up shares for a more extensive period than required by Article 27 (of the CSRC’s (2005) stipulations), increased confidence on the part of the controller would be conveyed in respect of the underlying company’s future earnings capacity. Consistent with the Leland and Pyle (1977) signalling model, larger and more extensive lock-ups should act to support higher share valuations in the issuer. Application of this argument is a little more complicated in the case of the share reform issue though, as the “lock-ins” may owe as much to political motives as commercially-driven ones, given the nature of state-related controlling shareholder in mainland PRC-incorporated issuers. The decision to extend


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the lock-up period beyond the minimum required may therefore reflect something about the nature of the state-related shareowner as well as the “confidence” of the controlling party (in relation to future cash flow returns). Clearly, research into the determination of the precise lock-up stipulations declared and their impact upon A-share pricing would be helpful to the present debate. It would be especially useful to know how A-share prices respond in the immediate run-up to, and conclusion, of lock-up expiry. In answering the final question, contributions from the IPO literature may be potentially valuable. For instance, in Espenlaub et al.’s (2001) study of “lock-in” arrangements for UK IPO firms, a marked downturn in returns is noted around the time of lock-up expiry. They also cite (p. 1236 of their paper) evidence of negative price adjustments at such lock-up expiry points in relation to US-listed firms. Their findings for the UK are perhaps of greater import to the present study because they note that IPO lock-in arrangements have much “greater variability” than the more “standardised” US practice. Clearly, the expiry of the various moratoria in China’s share reform programme exhibit some degree of variance. While there are significant differences between IPOs and the “Split Share Structure” reform programme in relation to the economic significance of the lock-up arrangements, the general principle advanced in Espenlaub et al. (2001) is germane. In verbatim, they note that: It is argued that lock-ins may serve to over come adverse selection and agency problems arising from information asymmetries between informed insiders [. . .] and less informed [. . .] shareholders and investors [. . .] (Espenlaub et al., 2001, p. 1276).

The information asymmetry issue is likely to be very pronounced in the share reform programme. However, the declared lock-up provisions may be somewhat difficult to quantify in some cases. An example would be where the controlling player not only declares a lock-up arrangement for a particular period but also a minimum price for any potential subsequent disposal of shares (beyond the declared lock-up period). A good example of this is found in the reform proposal of Jiangxi Copper (14 March 2008), in which its largest domestic stakeholder Jiangxi Copper Corporation (JCC), declared inter alia that it: [. . .] undertakes that the originally non-tradable shares held [. . .] will be subject to the Moratorium Period of 36 months from the date of the completion of the Share Reform Plan. JCC further undertakes that if it sells the originally non-tradable shares through the Shanghai Stock Exchange within one year after the Moratorium Period, it will not sell such shares at less than RMB9.00 per share. In the event that JCC fails to fulfill this undertaking, all monies received from the disposal [. . .] shall be paid to the account of the Company (Jiangxi Copper Company Limited, 2006, p. 2, capitalized letters shown as reported).

As an empirical study, it would be of interest to find out how particular A-listed issuers have fared in the recent downturn in relation to the specific terms of the lock-up moratoria on the re-designated controlling parties’ shares. One might conjecture again that, ceteris paribus, the longer the period of the trading moratoria and/or the higher the declared premium on any subsequent disposal price, the more robust stock performance prior to and at the point of lock-up expiry. Again, this issue awaits analysis.

4. Permissible tradable share combinations: the interplay of A-, B- and H-shares While reform of non-tradable stock into G- and, eventually, into a purely tradable form serves to streamline the equity structure of PRC-incorporated enterprises, many issuers will still retain other tradable stock types. As reported in Table II, and based upon data extracted from both HKEx and the CSRC, five possible tradable share configurations apply in relation to mainland-incorporated enterprises. The most obvious one is a single A-share listing (1,429 issuers). The next, in terms of listing numbers, is the A- and B-listing combination (86 issuers). 23 issuers also have a single B- share listing, 55 a single H-share listing and 55 a pairing of A- and H-listings. Until quite recently, issuers were not able to have concurrent B- and H-listings. However, the June 2008 H-share IPO of Shandong Chenming changed all of that. This listing was significant because the issuer already had A- and B-share listings in place prior to its Hong Kong (H-) IPO. Moreover, the controlling shareholder, as explained in its “Global Offering” prospectus document (Shandong Chenming, 2008, p. 100), had its share reform proposal accepted by tradable A-investors more than two years prior to its Hong Kong H-share IPO, with a proviso established at that point that it would lock-up newly designated shares for a period of 48 months. Consistent with comments in Section 3 of this paper, the Shandong Chenming prospectus document (pp. 100-01) made it apparent that tradable B-share investors would not benefit from the reform’s compensation package. The Shandong Chenming case, in which a tradable A-, B- and


Issuers Issuers Issuers with with with A-share B-share H-share listings listings listingsa Shanghai 854 54 Shenzhen 727 55 Hong Kong – – Total 1,581 109 Number of listings for the six possible tradable (A-, B- and H-) share configurations Single A-listing (Shanghai and Shenzhen combined)b: 1,439 issuers Single B-listing (Shanghai and Shenzhen combined)c: 23 issuers Concurrent A- and B-listings (Shanghai and Shenzhen combined)c 86 issuers Single H- listing (H: Hong Kong): 55 issuers Concurrent A- and H-listingsd (H: Hong Kong; and A: either Shanghai or Shenzhen): 55 issuers Concurrent A-, B- and H-listings (H: Hong Kong; and A: Shanghai): 1 issuer

– – 110 110

Notes: Share numbers were determined from Hong Kong Exchanges and Clearing Company Limited (2008); aData exclude H-share listings on HKEx’s second board GEM forum. The same source indicated an additional 40 such listings; bDeduced from number of A-share listings (1,581) less number of issuers with concurrent A- and B-listings (b, 86) less number of issuers with concurrent A- and H-share listings (d, 55 – 1). Shandong Chenming which has triple A-, B- and H-listed status will be represented in the data twice: in the figure for A- and B-pairings and in the one for A- and H-pairings; c Figures determined from CSRC web site (CSRC (n.d.)). Given an effective moratorium on B-share IPOs in Shanghai and Shenzhen, figures for August 2007 are assumed relevant to October 2008; d Figure obtained courtesy of Hong Kong Exchanges and Clearing Company Limited

Table II. Details of the number of A-, B- and H-share listings in the three respective Chinese markets (Shanghai and Shenzhen: A- and B-; and Hong Kong: H-)

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H-combination is apparent, indicates a further tradable stock configuration pattern on top of the five already discussed. Perhaps, the most important tradable stock combination is the one relating to issuers (55) with concurrent A- and H-pairings. Issuers within this group represent some of China’s most prominent SOEs (McGuinness, 2008, pp. 112-13), For instance, all of China’s SOE banks, as listed in Hong Kong between 2005 and 2007, have adjoining A-share listings in Shanghai. This elite group comprises, in descending order of asset size, ICBC, Bank of China, China Construction Bank, Bank of Communications, China Merchants Bank and China CITIC Bank. In addition, top-ranked Shanghai-listed companies such as PetroChina, Sinopec, China Life and China Shenhua all enjoy H-listed status on HKEx. According to figures disclosed on HKEx’s “China Stock Market Web site” (under “Listed Company”), the four companies mentioned plus ICBC, Bank of China and China Merchants Bank, occupied the top-seven slots in Shanghai in terms of market capitalization as of 17 October 2008. As noted at the outset, virtually all controlling shareholders in issuers with tradable A-share listings have now garnered support for the reform of their shares. However, for issuers with a single B-or a single H-share listing (i.e. those without accompanying A-listing), the various share reform provisions do not apply. Domestic stakeholders in such concerns therefore still hold shares in a non-tradable form. 5. Arrangements governing the sale of newly tradable shares and the related disclosure requirements With the recent expiry of certain key parts of the moratoria on the reform (G-) shares, the previously non-tradable stakes of a number of domestic players are now potentially available for sale. In the early part of 2008, there were a number of cases where domestic shareowners chose to dispose of slices of such holdings. However, the CSRC recently intervened (in April 2008) to introduce a “block-sale” restriction. The essence of this measure is that a stakeholder with a parcel of recently unfrozen shares (i.e. shares completely unfettered by trading restriction) is prevented from freely disposing of large amounts of the stock in the organized/regular secondary market. Specifically, no more than one per cent of the issuer’s outstanding shares can be sold, by a controlling party holding recently converted shares, through the regular secondary market during any 30-day period (Ren and Chen, 2008). In light of the new regulations, large blocks of stock must be placed off-market. In some sense, the original stipulations on “Split Share Structure” reform, as set out in the CSRC’s (2005) provisions, highlight the preference for such a disposal mechanism. Specifically, Article 28 states that: A former non-tradable shareholder to sell a relatively large quantity of shares of a listed company may handle the deal by means of a share placement with specific investors (CSRC, 2005, Article 28).

The second important development with regard to the disposal of unfrozen G-shares concerns stipulations by the CSRC in July 2008 that the details of any disposals should be made public by disclosing the transactions in a timely manner via China’s Securities Depository Trust & Clearing entity (Ren and Chen, 2008). This second initiative means that the selling intention of the disposing party should be quickly signalled to the

overall market so that any adverse market correction can be quickly transmitted to all market participants. The increased transparency from this disclosure measure is surely intended to discourage the hitherto non-tradable stock holders from discretely selling-down holdings in an incremental fashion. Implementation of the two pillars – the block-sale restriction and the increased transparency surrounding the sale of newly converted stock – is clearly designed to dampen the building risk premium relating to state share disposals. These measures, along with others that market authorities might potentially unfurl, have to be interpreted within the context of the relatively weak market sentiment that now surrounds the A-share market, with many tradable A-share prices as of October 2008 at levels below 40 per cent of their October/November 2007 peak valuations. 6. Conclusions The discussions in this paper help to bring into focus a highly topical issue within the context of the Chinese equity market. The various provisions surrounding the eventual metamorphosis of non-tradable stock into an unfettered tradable form are clearly significant and numerous, and include the various lock-up arrangements imposed on controlling shareholders, the compensation plans for existing tradable A-share investors, the mobilization of voting rights of tradable A-share investors in relation to the support of reform proposals, the recent CSRC-initiative in introducing block-sale restrictions and, finally, measures to increase transparency surrounding the sale of recently converted shares. For certain issuers, a discernible risk premium has been building in the last year as particular parts of the moratoria imposed on controlling stakes have either lapsed or are set to do so in the very near future. While this raises the spectre of large-scale state-share disposals, the amount of activity in this area is likely to be heavily constrained through state intervention. Even where some level of ascent is granted, block-sale restrictions serve to limit or, at least, slow the scale of disposals. Instead, the “Split Share Structure” reform can be largely seen as one intended to simplify and stream-line the old share configuration of the PRC-incorporated SOE. Nonetheless, some significant disposal activities will inevitably occur. Prior related evidence in Chen et al. (2008), for transfers of controlling non-tradable stakes in SOE listed issuers between 1996 and 2000, points to positive earnings and stock price effects when domestic controlling stakes are acquired by private investors. While disposals (or transfers) through the reform programme will be carefully scrutinized, the results in Chen et al. offer some comfort for existing tradable A-share investors. On a less positive note, Chen et al. (2008) found that earnings and stock price gains were generally not apparent for sales of parcels of stock between state-related parties. While the reform is highly significant in terms of its remit, extending to over 1,500 A-listed issuers, it does nothing to streamline the various tradable share types (A-, Band H-) that currently exist. Even though the majority of listed issuers only have a single A-share listing, the largest and perhaps most important of SOEs have concurrent A- (Shanghai) and H- (Hong Kong) listings. Pricing differences between the two sets of stocks, largely as a result of trading restrictions brought-on by capital account restrictions relevant to mainland China, suggest that an attempt to merge the two stock types is some way off. Moreover, the likelihood that China will retain


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significant capital account restrictions would suggest that the A- and H-markets will continue to serve separate sets of investors. As for the B-shares, rumours circulate from time-to-time as to possible further reform of the market. In a practical sense, the small number of issuers and the relatively small float and market capitalization size of the B-market, mean that the authorities may continue to resist enlarging the market, and therefore extend the effective moratoria on B-share IPOs into perpetuity. With more and more listings wending their way through to the Shanghai and Shenzhen A-share markets in coming years, the B-share market will likely be further marginalized in terms of its contribution to total listing numbers and overall market volumes. Notes 1. B-shares are often regarded as “Foreign” stock despite the fact that since March 2001 mainland PRC resident investors, with approved foreign exchange accounts, have been able to trade in the market. Prior to this, the B-share market was legally confined to trades between foreign investors (i.e. Hong Kong and other non-mainland Chinese investors). For details of the March 2001 B-share market reforms, see McGuinness (2002). 2. Thanks are due to Charlie Cai for suggesting this area as a potential avenue for future research. References Anderlini, J. (2005), “In China’s alphabet of struggling share categories, ‘G’ spells go”, South China Morning Post, Business, 5 September, p. B14. Annual Report (2007), “Sinopec ‘Annual Report’ for 2007 posted on HKEx”, available at: www. hkexnews.hk/listedco/listconews/sehk/20080407/LTN20080407153.pdf Arquette, G.C., Brown, W.O. Jr and Burdekin, R.C.K. (2008), “US ADR and Hong Kong H-share discounts of Shanghai-listed firms”, Journal of Banking & Finance, Vol. 32, pp. 1916-27. Birtch, T.A. and McGuinness, P.B. (2008), “The 2001-2005 price convergence in the A- and H-shares of Chinese state-owned enterprises: a story of unprecedented economic, regulatory and political change”, Journal of Financial Regulation and Compliance, Vol. 16 No. 3, pp. 239-50. Chan, K., Menkveld, A.J. and Yang, Z. (2008), “Information asymmetry and asset prices: evidence from the China foreign share discount”, The Journal of Finance, Vol. 63 No. 1, pp. 159-96. Chen, G., Firth, M., Xin, Y. and Xu, L. (2008), “Control transfers, privatization, and corporate performance: efficiency gains in china’s listed companies”, Journal of Financial and Quantitative Analysis, Vol. 43 No. 1, pp. 161-90. China Daily (2007), “Watchdog on SOEs sets rules”, China Daily, available at: www.Chinadaily. com.cn CSRC (n.d.), “Statistical information”, “Summary by shares categories” for the August 2007 month-end, available at: www.csrc.com.cn/ CSRC (2005), Circular on Issues Relating to the Pilot Reform of Listed Companies Split Share Structure, China Securities Regulatory Commission, available at: www.csrc.com.cn/en/jsp/ detail.jsp?infoid ¼ 1129278662100&type ¼ CMS.STD) (accessed 14 October 2005). Espenlaub, S., Goergen, M. and Khurshed, A. (2001), “IPO lock-in agreements in the UK”, Journal of Business Finance & Accounting, Vol. 28 Nos 9/10, pp. 1235-78. Fang, H., Jun, S. and Chong, T-L. (2008), “Testing for structural change in the nontradable share reform of the Chinese stock market”, The Chinese Economy, Vol. 42 No. 2, pp. 24-33.

Fei, L., Balatbat, M. and Czernkowski, R. (2008), “The reform of split share structure in China and its effects on the capital market: an empirical study”, available at: www.cbe.anu.edu.au/ schools/fas/documents/Balatbat_01May2008_004.pdf (accessed 14 April). Feng, L. and Xu, W. (2007), “Has the Reform of nontradable shares raised prices: an event-study analysis”, Emerging Markets Finance and Trade, Vol. 43 No. 2, pp. 33-62. Ferguson, M. and McGuinness, P.B. (2004), “Reform in the Chinese securities industry: the role of QFII schemes in the corporate governance process”, Business Horizons, Vol. 47 No. 2, pp. 53-61. Hong Kong Exchanges and Clearing Company Limited (2008), “Market highlights”, 17 October 2008, China Stock Markets web site, available at: www.hkex.com.hk/csm/ Jiangxi Copper Company Limited (2006), “Announcement adjusted share reform plan proposed by the holders of non-tradable shares of the company”, available at: www.hkexnews.hk/ listedco/listconews/sehk/20060315/LTN20060315064.pdf (accessed 14 March). Lee, S.L.J. (2008), “From non-tradable to tradable shares: split share structure reform of China’s listed companies”, Journal of Corporate Law Studies, 2008, April, pp. 57-78. Leland, H. and Pyle, D. (1977), “Information asymmetries, financial structure and financial intermediation”, Journal of Finance, Vol. 32, pp. 371-87. Li, K., Wang, T., Cheung, Y-L. and Jiang, P. (2008), “Privatization risk sharing: evidence from the split share structure reform in China”, available at: http://webapps2.ucalgary.ca/ , nfa99/ openconf/papers/230.pdf McGuinness, P.B. (2002), “Reform in China’s B share markets and the shrinking A/B share price differential”, Applied Economics Letters, Vol. 9, pp. 705-9. McGuinness, P.B. (2006), “The privatisation process and evolving share ownership structure of mainland China’s leading state-owned enterprises”, Journal of Financial Regulation and Compliance, Vol. 14 No. 1, pp. 37-46. McGuinness, P.B. (2008), “The global pursuit of Chinese stock issuers”, The Future of Asian Financial Centres – Challenges and Opportunities for the City of London, Research Republic, City of London Publication, London, pp. 110-9, available at: http://213.86.34.248/NR/ rdonlyres/11CA0BEC-7946-46DB-9552-FB2A0C4EDA91/0/BC_RS_asiaFC.pdf (accessed October). O’Neill, M. (2005a), “China state share sale spooks market: regulator names four companies to start revived scheme”, South China Morning Post, Business, 10 May, p. B1. O’Neill, M. (2005b), “China hastens sale of state shares; officials rule out compensation for holders of B and H shares”, South China Morning Post, Business Post, 12 September, p. B1. Ren, D. and Chen, A. (2008), “CSRC to Disclose disposals of previously non-tradable shares”, South China Morning Post, Business, 22 July, p. B4. Shandong Chenming (2008), Global Offering (Prospectus Document), Shandong Chenming Paper Holdings, Hong Kong, available at: www.hkexnews.hk/listedco/listconews/sehk/ 20080604/LTN20080604006.htm (accessed 4 June). Sinopec (2006a), “Indicative notice regarding the share reform proposal”, China Petroleum & Chemical Corporation, notice posted on HKEx web site, available at: www.hkexnews.hk/ listedco/listconews/sehk/20060821/LTN20060821071.pdf (accessed 18 August). Sinopec (2006b), “Share reform announcement”, China Petroleum & Chemical Corporation, notice posted on HKEx web site available at: www.hkexnews.hk/listedco/listconews/sehk/ 20060828/LTN20060828070.pdf (accessed 25 August).


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Sinopec (2006c), “Announcing relating to results of the communication among shareholders concerning the share reform scheme”, China Petroleum & Chemical Corporation, notice posted on HKEx web site, available at: www.hkexnews.hk/listedco/listconews/sehk/ 20060906/LTN20060906055.pdf (accessed 5 September). Sinopec (2006d), “Announcement of the first notification of the convention of shareholders’ meeting of a share market relating to the share reform scheme”, China Petroleum & Chemical Corporation, notice posted on HKEx web site, available at: www.hkexnews.hk/ listedco/listconews/sehk/20060911/LTN20060911085.pdf (accessed 11 September). Sinopec (2006e), “Announcement of the voting results at the shareholders’ meeting of A share market relating to the share reform scheme”, China Petroleum & Chemical Corporation, notice posted on HKEx web site, available at: www.hkexnews.hk/listedco/listconews/ sehk/20060926/LTN20060926086.pdf (accessed 25 September). Sinopec (2006f), “Announcement on the implementation of the share reform scheme”, notice posted on HKEx web site, available at: www.hkexnews.hk/listedco/listconews/sehk/ 20060928/LTN20060928072.pdf (accessed 27 September). Sinopec Interim Report (2008) Sinopec Interim Report, posted on HKEx available at: www. hkexnews.hk/listedco/listconews/sehk/20080826/LTN20080826137.pdf Su, Q., Chong, T-L. and Yan, K-M. (2007), “On the convergence of the Chinese and Hong Kong stock markets: a cointegration analysis of the A and H shares”, Applied Financial Economics, Vol. 17, pp. 1349-56. Sun, Q. and Tong, W.H-S. (2000), “The effect of market segmentation on stock prices: the China syndrome”, Journal of Banking & Finance, Vol. 24, pp. 1875-902. Tang, G. (2005), “State shares to be traded after second trial scheme”, The Standard, 28 June. Corresponding author Paul B. McGuinness can be contacted at: [email protected]



Market risk disclosure: evidence from Malaysian listed firms

Market risk disclosure

Radiah Othman Research Management Institute, Universiti Teknologi Mara, Shah Alam, Malaysia, and

57

Rashid Ameer Faculty of Accountancy, Universiti Teknologi Mara, Shah Alam, Malaysia Abstract Purpose – The purpose of this paper is to investigate the market risk disclosure practices among Malaysian listed firms. Specifically, it aims to examine the level of compliance with FRS132: Financial Instruments – Disclosure and Presentation for financial periods beginning or after 2006. Design/methodology/approach – The approach taken is content analysis and coding procedure. Findings – Although a large number of companies have shown compliance with FRS132 in relation to disclosing the financial risk management policy, there are systematic differences across companies in terms of level of details (i.e. qualitative and quantitative) disclosure. Interest rate disclosure was the most mentioned category and the credit risk was the least mentioned category of market risk. There is telling evidence that most Malaysian firms did not engage in hedging any type of market risk over the reporting period of 2006-2007. Research limitations/implications – There is a need for some standardized risk reporting format to achieve greater financial transparency to make investors aware of the market risks. Originality/value – This is believed to be the first study to provide survey findings on the use of derivatives instruments by listed firms in Malaysia. Keywords Disclosure, Financial reporting, Malaysia, Financial risk Paper type Research paper

1. Introduction Estimation, presentation and dissemination of financial risk measures are the basis of risk reporting by financial institutions and other organizations (Holt, 2006). Raghavan and Li (2006) argue that the structural economic environment and the regulatory changes have led to the evolution of the both qualitative and quantitative market risk reporting by the organizations. Market risk is defined as the risk of loss arising from adverse changes in market rates and prices such as interest rates, currency exchange rates, commodity prices, or equity prices. Derivatives are an integral part of market risk management policy. Derivatives are typically off-balance sheet items. Their accompanying rights and obligations (and hence gains and losses) usually circumvent financial statement disclosure. In the absence of disclosure of these off-balance sheet items, it has been argued that investors’ are unable to assess all factors that affect a firm’s financial condition[1]. On the other hand, according to proprietary costs theory, firms limit disclosure of potential risk information to the financial market because of the existence of disclosure related, or proprietary, costs. Firms may not like to disclose extensive information that might have future repercussions for their bare existence due to sensitivity of such information.


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This paper investigates the market risk disclosure of the firms listed on the three boards – main, second and MESDAQ boards in Malaysia, respectively, for the reporting period of 2006-2007 (2006 is the first reporting period following the release of the FRS132 or alternatively Malaysian Accounting Standards Board – MASB 24). We believe that this is the first study to examine FRS132 compliance in Malaysia. Previous studies (Lazar et al., 2006) have examined the adoption of FRS standards in general, and do not explore the compliance with one FRS standard in particular. Our paper is similar to Talha et al. (2007) who examined the competitive disadvantage of segmental disclosure for sample of 116 firms under the requirement of MASB 22 Segment Reporting, and the risk reporting issues in Islamic Banks in Malaysia examined by Ariffin (2004). The following section discusses the specific requirements of the FRS132, while the ensuing sections discuss and illustrate the format, location, and flexibility in providing disclosure. After discussing the requirements, we then identify the research questions followed by the results and discussion of the analysis. 2. Institutional setting in Malaysia The MASB (2005) is the standard setting body for Financial Reporting Standards (FRS), including standards for Islamic accounting and reporting in Malaysia. Prior to the setting up of the MASB, the accountancy bodies of the Malaysian Institute of Accountants and Malaysian Institute of Certified Public Accountants collaborated and issued FRS. The situation changed when in 2005, when MASB renamed and renumbered the MASB standards to FRS. This is to be in line with the objective of the International Accounting Standard Board, of which Malaysia is a member, to work towards convergence to a single set of accounting standards worldwide, (known as the International Financial Reporting Standards (IFRS). As MASB standards were adoption of IAS, there were no major areas of differences between the standards when the MASB standards were renumbered and renamed to FRS (Lazar et al., 2006). MASB introduced FRS132: Financial Instruments – Disclosure and Presentation (IAS32) for the first time to be adopted by Malaysian firms for financial periods beginning or after 2006. This standard exposes the type of market risk being faced by listed companies in Malaysia, and it can be seen as an attempt to make FRS in Malaysia at par with IFRS. Although it has planned to introduce FRS139 that deals with principles governing the recognition and measurement of financial assets and financial liabilities but its implementation date has not been announced yet. 2.1 FRS132 disclosure requirements Financial instruments include financial assets and financial liabilities. Financial assets represent a contractual right to receive cash in the future and correspondingly financial liabilities represent a contractual obligation to deliver cash in the future. Derivative financial instruments meet the definition of the financial instrument because these create rights and obligations that have the effect of transferring between the parties to the instrument one of more of the financial risks inherent in an underlying primary financial instrument. Derivative financial instruments are used by firms for risk management purposes such as foreign exchange forward contracts, interest rate swaps (IRS), foreign currency swaps among others. On inception, some derivative instruments such as foreign currency swaps, embody both a right and obligation to make an exchange of foreign currencies in future, and as exchange rate changes those

terms may become either favorable or unfavorable represents the financial gain (loss) to the firms. According to paragraph 56 of FRS132 Financial Instrument – Disclosure and Presentation, there is a specific requirement that an entity shall describe its financial risk management objectives and policies, including its policy for hedging each main type of forecast transaction for which hedge accounting is used. Similarly paragraph 58 of FRS132 Financial Instrument specifies that an entity shall disclose a description of hedge; nature of risk being hedged, and a description of the financial instruments designated as hedging instruments and their fair values at the balance sheet date. For each type of market risk such as interest rate risk, an entity shall disclose information about its exposure to interest rate risk, including effective interest rates and maturity dates (or contractual re-pricing). On the other hand, for credit risk an entity shall disclose the amount that best represents its maximum credit risk exposure as at balance sheet date, without taking into account of the fair value of any collateral, in the event of other parties failing to perform their obligations under financial instruments, and significant concentration of credit risk. 2.2 Format, location and flexibility in disclosure The standard prescribes that the disclosure may include a combination of narrative descriptions and quantified data, as appropriate to the nature of the instruments and their relative significance to an entity. For instance, information about an individual financial instrument may be important when it is a material component of an entity’s capital structure. We present below suggested format for the foreign exchange (or currency risk), interest rate and credit risk by MASB. 2.3 Foreign exchange risk disclosure format When hedging instruments held or issued by an entity, either individually or as a class, creates a potentially significant exposure to the foreign exchange, commodity and interest rate risks. Their terms and conditions that warrant disclosure are: the principal, stated face value, for derivative such as IRS, forwards and future contracts; date of maturity, early settlement option held by either party to the instrument, including the period in which, or date at which, the options can be exercised and the conversion or exchange ratio. 2.4 Interest rate risk disclosure format The carrying amount of financial instruments exposed to interest rate risk may be presented in tabular form, grouped by those that are contracted to mature or be re-priced in the following periods after the balance sheet date. It can be one year or less; in more than one year but not more than two years; in more than two years but not more than three years; in more than three years but not more than four years; in more than fours but not more than five years; and more than five years. Interest rate information may be disclosed for individual instruments, or weighted average rates or a range of rates may be presented for each class of financial instrument. 2.5 Credit risk disclosure format The disclosure of the financial assets exposed to credit risk shall include the carrying amount of the assets in the balance sheet, net of any provisions for loss.


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For example, in the case of an IRS carried at fair value, the maximum exposure to loss at the balance sheet date is normally the carrying amount because it represents the cost, at current market rates, of replacing the swap in the event of default. Besides, that a financial asset subject to legally enforceable right of set-off against a financial liability shall be disclosed. It is intriguing to learn that even though MASB advise companies to disclose liquidity risk but no format has been suggested to date. We present evidence from Malaysian firms because there has been no comprehensive study on market risk disclosure. Furthermore, it has been suggested that the market risk disclosure is a topic of great economic significance given the scale of global derivative trading (Seow and Tam, 2002). Previous studies on the market risk disclosure (primarily in the USA) have either focused on the different categories of market risk individually, or examined all such market risks but focusing on the nature of disclosure, i.e. qualitative and quantitative. For instance, Rajgopal (1999) examined the commodity price risk exposure of oil and gas producers, while, Blankly et al. (2002) examined the qualitative and quantitative market risk disclosure under SEC requirement. Recently, attention has shifted towards investigating the compliance with a particular derivatives reporting standard. Abdelghany (2005) examined quantitative and qualitative disclosure of market risk under FFR No. 48, and Bhamornsiri and Schroeder (2004) examined disclosure of information on derivatives under SFAS No. 133 using sample of DOW30 companies. Some studies have empirically investigated the value relevance of market risk disclosure (Lim and Tan, 2007; Seow and Tam, 2002; Venkatachalam, 1996). For instance, Lim and Tan (2007) adopted a novel approach to investigate the value relevance of the market risks quantified using value-at-risk technique as suggested by Choudry (2001), whereas Seow and Tam (2002) examined the relationship between share returns and the quantitative disclosure of derivatives notional amount, fair value, gains and losses for the US banks. Emm et al. (2007) examined the best choice and best practices of the corporate risk management disclosure using 10-k filings. They find propensity of companies to use VaR, has been associated with greater use of derivatives and concerns about losing competitiveness from revealing proprietary information, whereas, propensity to use tabular method of presentation has been associated with greater exposure of interest rate and commodity risks as well as greatest demand for external financing. Other non-US studies are – Linsley and Shrives (2006, 2005, 2000) and Abraham and Cox (2007) for the UK. Linsley and Shrives (2006) found that there is a significant association between the number of risk disclosures and company size for 79 UK listed firms; and the most important benefit arising from improved risk disclosure by firms is a reduction in the cost of capital. They argue that if the market risks are disclosed, then the providers of capital may remove a part of the premium that is incorporated in the cost of capital for uncertainty concerning the firm’s risk position. Abraham and Cox (2007) report that long-term institutional investor in the UK has investment preference for firms with lower level of risk disclosure (which also include internal risk control reporting). Kaju¨ter (2001) found lack of systematic risk disclosure of German companies under the German Accounting Standard 5 “Risk Reporting”, which became effective after 31 December 2000. Beattie et al. (2004) examined in detail the narrative of forward looking risk-related disclosure in the UK using content analysis. Beretta and Bozzolan (2004) found significant relationship between firm size and risk disclosure for Italian firms.

3. Research question The purpose of this paper is to determine the extent to which Malaysian firms are providing market risk-related disclosure (qualitative and/or quantitative) suggested under FRS132[2]. Thus, specific research questions are:


RQ1. Do companies disclose financial risk management objectives and policies?

61

RQ2. Do companies disclose the purpose of using derivative instruments? RQ3. Do companies disclose the types of market risks faced by them? RQ4. Do companies disclose the type of hedging instrument used to minimize market risks? RQ5. Do companies provide qualitative and/or quantitative disclosure relating to the hedge instruments for each type of market risk? RQ6. Do companies provide additional voluntary disclosure on other market risks? 4. Sample and methodology The population consists of all firms listed on the main, second and MESDAQ boards of Bursa Malaysia. We selected top 500 firms ranked by market capitalization as of year end in 2005. The information on adoption (or otherwise) of FRS132 by these firms was obtained from their annual reports for the financial year ended in 2006/2007. In some cases, we did not obtain annual report of the companies in English language from their investor relation Webpage, Company Announcement Page, and Audited Accounts Page of Bursa Malaysia, which reduced the number of sample to 429 firms. The final sample of companies according to listing board classification is described in Table I. There is relatively higher number of companies from main board, followed by firms from the second board. There are a lower number of firms from MESDAQ in the sample. The annual reports were downloaded from Bursa Malaysia Company Announcement Webpage in Adobe PDF format. To locate a firm’s disclosure on FRS132, the “Find” option in Adobe PDF was used to search for key terms such as “instrument”, “derivatives” and “hedges” in the downloaded PDF files. In cases where an annual report of a firm was not available from Bursa Company Announcement page, we downloaded the latest annual report for the year ended in 2006/2007 from firm web site to execute our search. We found that these key terms were found in the section titled “Financial Risk Management and Policies” in notes to the accounts in the annual report. We coded the objectives of financial risk management policy – speculative/ non-speculative (i.e. no trading in derivatives); three main types of market risk

Main board Overall Annual reports available for either 2006 or 2007 in English language

Listing board Second board MESDAQ

Total

241

89

115

445

228

89

112

429

Note: This table shows the number of firms in our sample distributed according to their listing board in Malaysia

Table I. Sample classification

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disclosure – interest rate risk, foreign exchange risk and credit risk; type of hedge instrument used to hedge interest rate and foreign exchange risk, quantitative disclosure related to hedge instrument amount, currency denomination, maturity, and reported profit (loss) using a nominal coding procedure (Appendix for detail). This coding procedure effectively leads to 0 and 1 dummy type variables for descriptive analysis and therefore overcomes the problem associated with counting words in a sentence (Abraham and Cox, 2007). 5. Results We present results of our investigation according to questions mentioned above (and where necessary a distinction among companies based on their listing board is provided in the tables): RQ1. Do companies disclose financial risk management objectives and policies? From Table II, it can be seen that 328 out of 429 firms in the sample have complied with FRS132 in relation to disclosing financial risk management policy. The compliance level among the main board and MESDAQ firms is relatively higher than second board firms: RQ2. Do companies disclose the purpose of using derivative instruments? From Table II, it can also be seen that only main board firms (11 per cent, all listed banks) categorize the risk management policy into trading and non-trading categories. Besides, main board listed banks, 148 out of 429 firms (34.49 per cent) explicitly state that they do not engage in speculative or trading activities in their financial risk management statement (see below), the number of such firms varies from a high of 90 on the main board to a low of 25 on the MESDAQ board: The Group uses derivative financial instruments in the form of forward foreign exchange contracts and interest rate swap contracts to hedge its exposure to foreign exchange arising from operating, financing and investing activities. In accordance with its treasury policy, the Group does not hold or issue derivative financial instruments for trading purposes (Kumpulan Guthrie Bhd, 2006).

Main board (per cent) Financial risk management statement and policy Yes 189 (82.90) No 39 (17.10) Total number of firms 228 Hedging objective Speculative 11 (4.82) Non-speculative 90 (39.47) No-disclosure 127 (55.70) Total number of firms 228

Table II.

Listing board Second board (per cent)

MESDAQ (per cent)

Total

61(68.54) 28 (31.46) 89

78 (69.64) 34 (30.35) 112

328 101 429

– 25 (28.09) 64 (71.91) 89

– 33 (29.46) 79 (70.54) 112

11 148 270 429

Note: This table reports the number of firms providing financial risk management and policy in their annual report for the financial year ending 2007 according to their listing on the main, second and MESDAQ boards, respectively

It is surprising to learn that 270 (62.93 per cent) firms do not exactly state that these firms are (are not) engaged in any speculative/trading activities using hedging instruments of any type. This lack of transparency might create ambiguities for financial statement readers to assess the riskiness of a firm. As suggested by Bhamornsiri and Schroeder (2004), a desire to conceal potentially risky or unfavorable information could be one reason, among other several possible reasons for this finding:


63

RQ3. Do companies disclose the types of market risks faced by them? As shown in Table III, there is remarkable variation in the market risk disclosure (according to type of risk), for instance, 154 (35.89 per cent) firms provide any kind of qualitative and/or quantitative disclosure for foreign exchange risk, 159 (37.06 per cent) for interest rate risk, and 111 (34.90 per cent) for credit risk, respectively. Hence, across the listing boards, we can conclude that interest rate disclosure was the most mentioned category and the credit risk was the least mentioned category of market risk. MESDAQ has the highest proportion of firms without any disclosure on foreign exchange risk and second board has almost no firm in our sample disclosing credit risk. The latter finding might seem to suggest a belief among companies that credit risk information was immaterial and therefore need not to be disclosed. We also further explore the qualitative and/or quantitative components of risk disclosure. It was noticed that overwhelming majority of the companies have followed MASB guidelines on reporting interest rate risk. The interest rate risk is shown as, re-priced in the following periods after the balance sheet date in one year or less and in more than one year but not more than two years; in more than two years but not more than three years; in more than three years but not more than four years; in more than fours but not more than five years; and more than five years. Interest rates information are disclosed for individual instruments, effective and/or weighted average rates or a range of rates are presented for each class of financial instrument (Table IV). On the other hand, a relatively small proportion of companies have only relied on the qualitative narratives for the interest disclosure:

Market risks disclosure Foreign exchange risk Yes No Total number of firms Interest rate risk Yes No Total number of firms Credit risk Yes No Total number of firms

Main board (per cent)


MESDAQ (per cent)

Total

93 (40.53) 135 (59.47) 228

35 (39.30) 54 (60.70) 89

26 (23.00) 86 (77.00) 112

154 275 429

101 (44.30) 127 (55.70) 228

25 (28.09) 64 (71.91) 89

33 (29.46) 79 (70.54) 112

159 270 429

13 (5.70) 215 (94.30) 228

– 89 (100) 89

9 (8.04) 103 (91.96) 112

111 318 429

Note: This table reports the number of firms providing qualitative and/or quantitative disclosure about the marker risk according to their listing on the main, second and MESDAQ boards, respectively

Table III.

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Table IV.

Effective interest rates (per cent)

Within one year

2.50-3.70

2,692,900

3.50-5.28 7.00-8.00 3.20-6.54 7.50-7.75 7.25

95,982,578 9,299,753 231,898 2,171,274 4,500,000

Financial asset Fixed deposits with licensed banks Financial liabilities Bankers acceptances Bank overdrafts Hire purchases liabilities Term loans Trust receipts

One to five More than years five years

Total 2,692,000

– – 416,151 2,528,061 –

95,982,578 9,299,753 648,049 4,699,335 4,500,000

Source: JAKS Resources Bhd (2006)

The Group’s policy on managing its interest rate risk is by maintaining a prudent mix of fixed and floating rate investments and borrowings (Malaysian Airline System Bhd, 2006).

From Table V, there is a telling evidence that most Malaysian firms do not engage in hedging market risk, i.e. 290 (67.6 per cent) firms have not reported use of either a forward, swap, option, and/or futures contract over the reporting period of 2006-2007 in our sample. Overall, 18 per cent of the Malaysian listed firms in our sample use forward contract for the transaction exposure which is relatively lower than 31 per cent for Hong Kong (Hu and Wang, 2006) and 87 per cent for the UK (Joseph, 2000), respectively. The number of firms using swap contract (5.70 per cent) is also lower than reported for the UK firms (18.90 per cent): RQ4. Do companies disclose the type of hedging instrument used to minimize market risks? The main board firms are predominantly the main users of the hedging instruments; whereas, second and MESDAQ board firms have a relatively small following in the use of hedge instruments. Among the main board firms, forward contracts are used in high

Table V.

Hedging instrument

Main board (per cent)


MESDAQ (per cent)

Total

Forward contract Swaps contract Forward and swaps contract Forward and options contract Forward, swaps, and options contract Forward, swaps, and futures contract Natural hedge Does not use any hedge instrument Total number of firms

61 (26.80) 13 (5.70) 10 (4.40) 1 (0.40) 8 (3.50) 2 (0.90) 13 (5.70) 120 (52.60) 228

11 (12.40) – – – – – 8 (9.00) 70 (78.60) 89

5 (4.50) – – – – – 7 (6.25) 100 (89.25) 112

77 13 10 1 8 2 28 290 429

Note: This table reports the number of firms providing qualitative and/or quantitative disclosure about the use of hedge instrument for controlling market risk according to their listing on the main, second and MESDAQ boards, respectively

proportion to hedge market risks followed by swap, and/or both forward and swap contracts. Besides, forward and swap contract, it was found that natural hedge (an internal hedging technique) is also being employed by the firms across three boards. A natural hedge consists of matching inflows and outflows with respect timing of settlement in the same currency. Table VI shows that 83 firms have used forward contracts for foreign exchange and interest rate risk which is higher than 53 firms reported for Hong Kong (Hu and Wang, 2006). In general, if foreign currency forward contracts provide firms more security against future foreign exchange rate uncertainties, then one would expect their use to be more strongly associated with the foreign currency exposure. We used a x 2 test to test the null hypothesis of no association between utilization of forward contracts and hedging foreign currency risk. The hypothesis is rejected (overall x 2 ¼ 35.19, p-value ¼ 0.0000) and using the Cramer test statistic, C (C ¼ 0.906) the association appears to be higher. On the other hand, foreign exchange futures contracts are not used by firms. Joseph (2000) suggests that low-utilization level of futures contracts may be due to the effects of daily resettlement which can adversely affect the liquidity of firms:


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RQ5. Do companies provide qualitative and/or quantitative disclosure relating to the hedge instruments for each type of market risk? We find that nature of market risk disclosure in terms of qualitative and quantitative detail is not similar across firms. Those firms which report using derivative contracts such as forward contracts provide mainly quantitative disclosure. Examples of quantitative disclosure on the amount, denomination, maturity and profit (loss) for foreign exchange contracts and IRS are as shown in Tables VII and VIII. Table VII shows the foreign currency forward contracts which have been entered by the group for its trade receivables and trade payables. The group has entered into IRS to convert floating rate liabilities to fixed rate liabilities and vice versa to reduce the group’s exposure from adverse fluctuations in interest rates on underlying debt instruments, as shown in Table VIII.

Hedging instrument Forward contract Swaps contract Forward and swap contract Forward, swap, option, futuresa Natural hedge Total number of firms

Main board Foreign Interest exchange rate risk risk

Listing board Second board Foreign Interest exchange rate risk risk

MESDAQ Foreign Interest exchange rate risk risk

5 12

58 3

– –

11 –

4 –

5 –

9

10

–

–

–

–

8 –

11 13

– –

– 8

– –

– 6

34

95

–

19

4

11

Notes: This table reports the number of firms using hedge instrument for controlling interest rate and foreign exchange risk according to their board listing on the main, second and MESDAQ boards, respectively. aFirm reporting combinations of hedge instruments are aggregated in this category

Table VI.

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US$ Sterling £ US$ Sterling £ e US$ US$ e US$ US$

Table VII.

Source: Dialog Group Bhd (2007)

Amount in foreign currency (FC)

Contractual rate 1 FC/RM

285,000 13,200 2,115,903 128,063 117,806 66,971 69,545 60,528 184,939 24,209

3.4780 6.9150 3.4830 6.7650 4.6375 3.3805 3.4270 4.6330 3.4550 3.4550

Interest rate swaps US$ term loan

Notional amount in RM (and equivalent in US$) RM 741.30 million (equivalent to US$210 million)

Effective period 28 February 2006 to 28 February 2008 28 February 2008 to 28 February 2012

US$ term loan

RM 529.50 (equivalent to US$150 million)

28 February 2006 to 28 February 2009 28 February 2009 to 28 February 2012

US$ term loan

RM 34.59 (equivalent to US$9.8 million)

27 July 2006 to 26 July 2010

US$ term loan

RM 34.50 (equivalent to US$9.8 million)

27 July 2006 to 26 July 2007 27 July 2007 to 26 July 2010

Ringgit five-seven year Islamic bond Table VIII.

RM 40 million

Source: Kumpulan Guthrie Bhd (2006)

28 February 2006 to 28 February 2008

Maturity 2 July 2007 9 July 2007 12 July 2007 16 July 2007 31 July 2007 1 August 2007 3 September 2007 14 September 2007 20 September 2007 28 September 2007

Weighted average rate p.a. 4.98-5.15 per cent for the entire tenor of liability 4.98-5.00 per cent for the entire tenor of liability provided the spread is in range 4.795-5 per cent for the entire tenure of liability Floating but capped at 6 per cent provided the six month LIBOR is within the specified ranges 6.425 per cent for the entire tenor of liability 5.6 per cent for the entire tenor of liability 5.6 per cent for the entire tenor of the liability, provided the spread is within the range Six months KLIBOR þ 1.80 per cent

Some firms which choose to combine both qualitative and quantitative disclosure on the amount, denomination, and maturity for derivatives: In April 2007, the Company entered into four swap transactions, each in a notional amount of USD55.0 million, and amounting to an aggregate amount of USD220.0 million, with the objective of reducing the interest cost on its USD220 million USD notes program (Note 42, Term Loan 16). The swaps, which are each for five years terminating on October 2011, are structured with upfront savings to the Company, and depending on the individual structure, losses are capped at between 1.75 per cent and 3.50 per cent per annum, in order that any exposure of the Company is limited. On two of the swaps, Ranhill is obliged to pay a fixed interest rate of 3.50 per cent and 3.35 per cent per annum in USD and is entitled to receive a floating interest rate per annum in USD, on a semi-annual basis, in April and October of each calendar year to termination. On the other two remaining swaps, Ranhill is obliged to pay a floating interest rate per annum in USD and will receive a fixed interest rate of at least 12.50 per cent per annum in USD on a semi-annual basis in April and October of each calendar year to termination (Ranhill Bhd, 2006).

RQ6. Do companies provide additional voluntary disclosure on other market risks? We also found that some firms have provided voluntary disclosure related to other categories of market risk for example: The Group is exposed to a significant concentration of credit risk, whereby significant outstanding balance of trade receivables as at 30 June 2007 is due from three (3) customers, represent approximately 55 per cent or RM7,300,841 of the net trade receivables (Padini Holdings Bhd, 2006). The Group’s investments in quoted securities are subject to fluctuations in market prices. As and when necessary, the group should consider and if found to be feasible, engage in KLCI Future purely for hedging purposes to mitigate the impact arising from the fluctuations in market price (MNRB Holdings Bhd, 2006). The market risk of the Group’s trading and non-trading portfolio is managed using value-at-risk approach to compute the market risk exposure of non-trading and trading portfolio. Value-at-risk is a statistical measure that estimates the potential change in portfolio value that may occur brought about by daily changes in market rates over a specified holding period at a specified confidence level under normal market conditions. For the Group’s trading portfolio, the Group’s value-at-risk measurement takes a more sophisticated form by taking into account the correlation effects of various instruments in the portfolio (AMMB Holdings Group Bhd, 2006).

6. Conclusion The aim of this paper is to investigate the market risk disclosure practices among Malaysian listed firms under FRS132: Financial Instruments – Disclosure and Presentation, following its adoption in the year 2006. Our results show that though majority of the firms studied (328 out of 429) had complied with FRS132, the extent of compliance varied. The majority did not state whether they engaged in any speculative activities using any hedging instrument. Interest rate disclosure was favored as compared to credit risk among the market risks categories studied. Over half of the


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firms did not engage in hedging market risk and forward contracts are commonly used to minimize market risk. Our finding seems to suggest that the type of hedging instrument used by a firm determines its nature of disclosure (quantitative/qualitative) in the annual report. The variation in terms of nature and extent of compliance disclosure among Malaysian firms reflects the critical need for some standardized reporting format or guidelines from the standard setting and regulatory bodies. While compliance is important; there is a greater need for financial transparency on market risk to cater the needs of various stakeholders. This is to ensure that financial information is of value and relevance, to the people relying on such disclosure. Notes 1. In the US, SFAS Nos. 80, 105, 107, 119, and 133 were issued progressively requiring information on derivative notional principal amount, credit exposure, fair value and gain or loss. 2. Bhamornsiri and Schroeder (2004) have also used a similar approach to examine qualitative and quantitative disclosure under SFAS N0.133 for the DOW30 companies in the USA. References Abdelghany, E.K. (2005), “Disclosure of market risk or accounting measures of risk: an empirical study”, Managerial Auditing Journal, Vol. 20 No. 8, pp. 867-75. Abraham, S. and Cox, P. (2007), “Analysing the determinants of narrative risk information in UK FTSE 100 annual report”, The British Accounting Review, Vol. 39 No. 3, pp. 227-48. AMMB Holdings Group Bhd (2006), AMMB Holdings Group Bhd Annual Report 2006, AMMB Holdings Group Bhd, Kuala Lumpur. Ariffin, N. (2004), “Transparency in Islamic banks: risk reporting issues”, paper presented at IIUM Accounting Conference II, Kuala Lumpur. Beattie, V., McInnes, W. and Fearnley, S. (2004), “A methodology for analysing and evaluating narratives in annual reports: a comprehensive descriptive profile and metrics for disclosure quality attributes”, Accounting Forum, Vol. 28 No. 3, pp. 205-36. Beretta, S. and Bozzolan, S. (2004), “A framework for the analysis of firm risk communication”, The International Journal of Accounting, Vol. 39 No. 3, pp. 265-88. Bhamornsiri, S. and Schroeder, G.R. (2004), “The disclosure of information on derivatives under SFAS No. 133 evidence from the DOW30”, Managerial Auditing Journal, Vol. 19 No. 5, pp. 669-80. Blankly, A., Lamb, R. and Schroeder, R. (2002), “The disclosure of information on market risk: evidence from the Dow 30”, Managerial Auditing Journal, Vol. 17 No. 8, pp. 438-51. Choudry, M. (2001), “Bank risk exposure and value-at-risk”, The Bond and Money Markets, Butterworth-Heinemann, Oxford, pp. 625-60. Dialog Group Bhd (2007), Dialog Group Bhd Annual Report 2007, Dialog Group Bhd, Petaling Jaya. Emm, E.K., Gay, D.G. and Lin, C-M. (2007), “Choices and best practices in corporate risk management disclosure”, Journal of Applied Corporate Finance, Vol. 10 No. 4, pp. 82-93. Holt, A.G. (2006), “The evolution of risk reporting”, in Ong, M.K. (Ed.), Risk Management A Modern Perspective, Academic Press/Elsevier, Burlington, MA, pp. 607-31.

Hu, C. and Wang, P. (2006), “The determinants of foreign currency hedging – evidence from Hong Kong non-financial firms”, Asia Pacific Financial Markets, Vol. 12, pp. 91-107. JAKS Resources Bhd (2006), JAKS Resources BhdAnnual Report 2006, JAKS Resources Bhd, Petaling Jaya. Joseph, N.L. (2000), “The choice of hedging techniques and the characteristics of UK industrial firms”, Journal of Multinational Financial Management, Vol. 10, pp. 161-84. Kaju¨ter, P. (2001), “Risikoberichterstattung: Empirische Befunde und der Entwurf des DRS 5”, Der Betrieb, Vol. 54 No. 3, pp. 105-11. Kumpulan Guthrie Bhd (2006), Kumpulan Guthrie Bhd Annual Report 2006, Kumpulan Guthrie Bhd, Kuala Lumpur. Lazar, J., Tan, L.L. and Othman, R. (2006), “Adoption of international financial reporting standards – an overview”, Accountants Today, June, pp. 18-21. Lim, Y.C. and Tan, M-S.P. (2007), “Value relevance of value-at-risk disclosure”, Review of Quantitative Finance and Accounting, Vol. 29, pp. 353-70. Linsley, M.P. and Shrives, J.P. (2000), “Risk management and reporting risk in the UK”, Journal of Risk, Vol. 3 No. 1, pp. 115-29. Linsley, M.P. and Shrives, J.P. (2005), “Disclosure of risk information in the banking sector”, Journal of Financial Regulation and Compliance, Vol. 13 No. 3, pp. 205-14. Linsley, M.P. and Shrives, J.P. (2006), “Risk reporting: a study of risk disclosures in the annual report of UK companies”, The British Accounting Review, Vol. 38 No. 4, pp. 387-404. Malaysian Airline System Bhd (2006), Malaysian Airline System Bhd Annual Report 2006, Malaysian Airline System Bhd, Kuala Lumpur. MASB (2005), Financial Reporting Standard FRS 132 Financial Instruments: Disclosure and Presentation, Malaysian Accounting Standard Board, Kuala Lumpur. MNRB Holdings Bhd (2006), MNRB Holdings Bhd Annual Report 2006, MNRB Holdings Bhd, Kuala Lumpur. Padini Holdings Bhd (2006), Padini Holdings Bhd Annual Report 2006, Padini Holdings Bhd, Shah Alam. Raghavan, R.V. and Li, A. (2006), “Emerging trends in risk reporting”, in Ong, M.K. (Ed.), Risk Management A Modern Perspective, Academic Press/Elsevier, Burlington, MA, pp. 633-50. Rajgopal, S. (1999), “Early evidence on the informativeness of the SEC’s market risk disclosures: the case of commodity price risk exposure of oil and gas producers”, The Accounting Review, July, pp. 251-80. Ranhill Bhd (2006), Ranhill Bhd Annual Report 2006, Ranhill Bhd, Kuala Lumpur. Seow, S.G. and Tam, K. (2002), “The usefulness of derivative-related accounting disclosures”, Review of Quantitative Finance and Accounting, Vol. 18, pp. 273-91. Talha, M., Sallehhuddin, A. and Mohammed, J. (2007), “Competitive disadvantage and segment disclosure: evidence from Malaysian listed companies”, International Journal of Commerce & Management, Vol. 17 No. 2, pp. 105-19. Venkatachalam, M. (1996), “Value-relevance of banks’ derivative disclosures”, Journal of Accounting and Economics, Vol. 22, pp. 327-55.



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Extent to which financial services compensation scheme can pursue claims assigned to it by investors whom it has compensated Joanna Gray University of Newcastle upon Tyne, Newcastle upon Tyne, UK Abstract Purpose – The paper’s aim is to report and comment on two preliminary issues that arose from claims being pursued by the Financial Services Compensation Scheme (FSCS) against Abbey National Treasury Services (ANTS) and NDF Administration Ltd (NDF). Design/methodology/approach – The paper outlines the facts and explains the decision. Findings – The FSCS commenced action against ANTS as assignee of the assigned claims and alleged that ANTS had collaborated with NDF in product development and promotion of the Structured Capital at Risk Products and was liable in negligence and misrepresentation to the investors whose claims it held as assignee. Having considered the arguments, the Judge concluded that FSA did have power to make rules enabling FSCS to take assignment of investor claims. Originality/value – The issues in this case go to the heart of the funding mechanism of the FSCS. The financing of such compensation schemes is a perennially controversial issue in every jurisdiction that has them. Keywords Legal decisions, Compensation, Financial services Paper type Viewpoint

Financial Services Compensation Scheme Ltd v. Abbey National Treasury Services plc: High Court Chancery Division: Mr Justice David Richards. Date of Judgment: 31 July 2008.


Facts This was a trial of two preliminary issues only that themselves arose from claims being pursued by the Financial Services Compensation Scheme (FSCS) against Abbey National Treasury Services (ANTS) and NDF Administration Ltd (NDF). Those claims had in turn been assigned to FSCS by some 1,800 individual retail investors who had received compensation from FSCS in respect of mis-selling claims against Independent Financial Advisers (IFAS) which were unlikely to be met by the IFAS concerned. The factual background to those original claims against the IFAS was briefly described by the Judge as follows before he set out the preliminary issues: The products in issue involved a lump sum investment which linked the return on maturity, by a pre-set formula, to the performance of a specified equity index. The return would be greater or less than the initial investment depending on the performance of the index, but it was geared in the case of most of the products, so that there might be a reduction of 2 per cent

or more for every 1 per cent fall in the index. There are 14 types or series of such products in issue in the action. FSCS has compensated approximately 1,800 retail investors in respect of losses suffered by them as a result of investing in one or more of the products between 1999 and 2002. All of the investors invested in the products after receiving a mailshot and/or tailored advice from an IFA, and they all suffered capital losses under the products when the products matured. The investors subsequently claimed compensation from FSCS for their losses on the grounds that the degree of risk under the products was not explained (or was misrepresented) to them by their IFA. FSCS determined that because of their financial circumstances, the IFAs were unable or were likely to be unable to meet the investors’ claims, and accordingly FSCS declared the IFAs to be “in default”. FSCS subsequently paid compensation to the investors, in return for which the investors assigned to FSCS their claims against their IFA and their claims against third parties such as ANTS and NDF. The products were promoted by NDF, with which the investor contracted. The proceeds of the products were invested in shares in an investment company established for the purpose and listed on the Dublin Stock Exchange. ANTS did not deal directly with investors but it created the products. It was responsible for establishing the investment company, acted as its investment adviser and was the counterparty which entered into an index swap transaction or equity linked deposit transaction with the investment company. NDF was subject, as regards its promotion of the products, to the relevant rules made first under the Financial Services Act 1986 (the 1986 Act) and, in relation to promotion after 1 December 2001, by the FSA under FSMA. FSCS contends that the marketing material for the products failed to make clear the risks associated with them and that investors were induced to invest in the products in reliance on misleading statements and material omissions. Its case is that if the marketing material had, as it puts it, fairly disclosed the degree of risk in the products, the investors would not have invested in them. It claims that NDF was in breach of the applicable rules regulating the contents of marketing material and its claims against NDF are for breach of statutory duty (Section 62 of the FSA 1986 and Section 150 of [. . .] The case against ANTS is that it collaborated with NDF in the development and promotion of the products and in marketing them to investors through IFAs. The claims are in negligence and misrepresentation and, by reason of a joint enterprise with NDF, breach of statutory duty. ANTS denies any liability. It pleads that the plans and promotional material were issued by NDF, and that it is a wholesale institution which has not given investment advice to retail investors or issued promotional material, whether as regards the products or otherwise.

The assignment of the claims was effected by the signature of those investors who were compensated by FSCS of terms governing the payment of that compensation which included the following provisions: [Section 3.4] We/I confirm that we/I have received no offer or payment of compensation of any kind in respect of the losses for which compensation is sought herein whether from the firm or any other person. We/I also confirm that we/I do not expect to receive any such compensation in the future. Any such payment of compensation received by us/me, we/I will pay to the Financial Services Compensation Scheme Limited in accordance with Section 4 of this form [. . .] [Section 3.8] We/I understand that: The FSCS Limited in its capacity as the Scheme Manager (under Part XV of the Financial Services and Markets Act 2000) will, upon payment of compensation pursuant hereto, take over all our/my rights and claims whatsoever against the firm and against any other party (“Third Party Claim”) in accordance with the terms of the investor’s agreement and acknowledgment contained in Section 4 hereof.

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Thereafter we/I will not be entitled to the benefit of any such rights and claims, save as provided in the said Section 4 [. . .] [Section 4.2] That all our/my rights against the firm in respect of the Protected Claim shall pass to and be assigned to the FSCS Limited absolutely on payment of compensation (or any part thereof) pursuant to the Rules and/or the Order. 4.3 That all our/my rights against any other person which constitute a “Third Party Claim” as defined in paragraph 13 hereunder shall pass to and be assigned to the FSCS Limited absolutely on payment of compensation (or any part thereof) pursuant to the Rules and/or the Order. 4.4 That upon payment of compensation (or any part thereof) we/I will no longer have the right to make any claim against the firm or any other such person in respect of the Protected Claim or any Third Party Claim, and that the right to make any such claims will be vested in the FSCS Limited pursuant to the Rules and/or the Order. We/I further acknowledge that any such sums which would otherwise be payable to me in respect of the Protected Claim (including any dividend or other payment in any liquidation or compromise with creditors or scheme of arrangement) or any Third Party Claim shall be paid instead to the FSCS Limited [. . .] 4.10 The FSCS Limited will conduct all proceedings and settlement negotiations regarding claims assigned by me reasonably and with due regard to my interest as well as its own. 4.11 The FSCS Limited will re-assign to me at my request any claim which it and, if relevant, its insurers decide at any time not to pursue further. 4.12 That we/I will provide such further assistance or authority as may be required by the FSCS Limited from time to time to give full effect to the vesting in it of all rights and claims under and for the purpose of this agreement. Insofar as any assignment provided for herein is ineffective in law or equity to vest any rights or claims in the FSCS Limited, the FSCS Limited will be subrogated to those rights or claims, and will be entitled to the proceeds of the Protected Claim and any Third Party Claim. All such proceeds will be paid to the FSCS Limited. 4.13 In this document, “Third Party Claim” means any right, claim or cause of action which the claimant has or may have against any other person than the firm or against any fund or property in the hands of any person other than the firm and arising out of the circumstances giving rise to the Protected Claim or otherwise relating to that claim, whether such claims shall arise in debt, breach of contract, tort, breach of trust or in any other manner whatsoever.

Action The FSCS commenced action against ANTS as assignee of the assigned claims and alleged that ANTS had collaborated with NDF in product development and promotion of the Structured Capital at Risk Products and was liable in negligence and misrepresentation to the investors whose claims it now held as assignee. FSCS also alleged that ANTS was liable jointly with NDF for breach of statutory duty in relation to these assigned investor claims. ANTS denied these claims but before they could be tried in substance the Judge had, on application of both parties, ordered the following two preliminary issues to be resolved: (1) Whether the assignments of investors’ claims against ANTS referred to in paragraphs 2 and 3 of the particulars of claim are void and ineffective on the ground that FSCS had no power to agree such assignments. (2) Whether the compensation paid by FSCS to investors is to be taken into account in the calculation of the loss recoverable by FSCS as assignee of the investors’ claims against ANTS.

Decision In relation to the first of the two issues, the Judge saw the key question as being whether Part XV of the Financial Services and Markets Act 2000 conferred power on the FSA to include in its rules which it made to establish and operate the FSCS any provision for assignment to it by investors of claims against third parties. For, of course, these third parties were not the same regulated person or persons whose default and inability to meet investor claims had led the investors to claim compensation from the FSCS in the first place. For if the Financial Services and Markets Act 2000 did not confer such rule-making power then FSA had acted ultra-vires in making the rules pursuant to which it took assignment of these investors’ claims against ANTS and NDF. The Judge examined the terms of the various statutory provisions within FSMA 2000 and the Insolvency Act 1986 which applied to the rules and guidance that FSA had made in relation to the FSCS which form part of the FSA Handbook of Rules and Guidance. These included Section 54 FSMA 2000 which enables the FSA to establish such a scheme for compensation of certain investors, Part XV (Sections 213-217) FSMA 2000 which gives more detail as to how the FSA may make provision for and operate such a scheme and the general power conferred on the FSA to make rules contained in Section 156 FSMA 2000. He also reviewed and analysed in some detail both the statutory history of Part XV FSMA 2000 and certain of the predecessor sector specific compensation schemes which it replaced and consolidated, as well as case law to date which had dealt with issues concerning investor claims assigned to the Investors Compensation Scheme (Investors’ Compensation Scheme Ltd v. West Bromwich Building Society, Investors’ Compensation Scheme Ltd v. Hopkin & Sons (a firm), Alford v. West Bromwich Building Society, Armitage v. West Bromwich Building Society [1998] 1 All ER 98 and Investors Compensation Scheme Ltd v. Cheltenham & Gloucester plc [1996] 2 BCLC 165.). The Investors Compensation Scheme was one of the predecessor schemes to the FSCS and had been established under the Financial Services Act 1986. Having considered the arguments made for ANTS and for FSA in relation to the validity of the power of FSA to make rules enabling FSCS to take assignment of investor claims the Judge concluded that FSA did have such a power for the following reasons: While such a provision is not an essential component of a compensation scheme, it is in my view an obvious provision and one which can properly be regarded as integral, rather than peripheral, to it. There is a clear connection between the payment of compensation where defendant A is unable to meet the claim and the assignment to the scheme manager not only of the claim against defendant A but also of claims for the same or largely the same loss against defendant B. It is, I would suggest, a provision which any reasonable person would regard as an obvious way in which the scheme could seek to recoup some or all of the compensation which it had been required to pay. I consider that the power to make such provision falls within Section 213(1) [FSMA 2000], but if I am wrong about that, it is in my view an incidental or supplemental matter within Section 156(2) [. . .]

The Judge now turned to the second of the two issues for resolution in these proceedings – whether the claim being pursued by FSCS against ANTS should be for an amount of damages nett of the compensation already paid by FSCS to the investors who had assigned their rights of action underlying the claim against ANTS.

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Although the court here did not address and decide the exact amount of the actual financial difference, this would make to the potential liability of ANTS to FSCS in respect of these claims it was clear and accepted by both parties that the difference in level of recovery achievable by FSCS against ANTS was very considerable. Counsel for ANTS had argued that without deduction of the compensation already paid the losses claimed for could be £21 million but if the court insisted that the losses take into account investor compensation already paid then they would amount only to some £1 million. So what was the appropriate level of loss recovery the FSCS could achieve on these assigned claims? Counsel for ANTS had argued that to allow the claims to be pursued gross would be to allow for double recovery for the investors while counsel for the FSCS had argued that the whole purpose of having investor claims assigned to it when it paid out compensation to investors was in order to enable it to recoup the costs of such compensation by pursuing those claims in respect of which compensation was paid, against third parties if need be. The Judge considered the effect of the terms of the assignment agreement between the FSCS and those investors to whom it had already paid compensation. He also took into account those FSCS rules which require it to pay any surplus recovery over and above compensation already paid to investors to also be paid over to those investors. He concluded that: [. . .] the provisions for assignment are themselves made solely as a means whereby FSCS can recoup its outlay. To give effect to this purpose it is necessary that there is assigned the gross claim, as is clearly the intention from [the FSCS rules and the assignment agreement he had considered] The inclusion of [such] provisions [. . .] are necessarily part of a scheme designed to achieve that purpose. [. . .] It would be an extraordinary position if the purpose of the assignment as set out in the scheme rules, both in terms of recouping FSCS and paying any surplus to the investors, would be defeated by an inability to include the provisions necessary to give effect to it.

Therefore, he ruled on this second preliminary issue that compensation already paid by FSCS to investors should not be taken into account in the computation of loss that it could recover as assignee of those investors’ claims against ANTS.

Comment Clearly, these issues went right to the heart of the funding mechanism of the FSCS. The financing of such compensation schemes is a perennially controversial issue in every jurisdiction that has them. This is because not just of the considerable costs and potential costs of such schemes but also the inevitable element of cross-subsidy inherent in those schemes funded by industry levies, as the FSCS is. This point was raised in the context of assignment of investor claims in the Investors Compensation Scheme Ltd v. West Bromwich Building Society case and adverted to by the Judge in the course of his judgment when he commented: [. . .] it is plainly implicit in a statutory object to create a system for the compensation, of a class of members of the public, that there should also be established an efficient system for the compensating authority to be able to recover from all persons whose misconduct has led to such compensation being necessary, contributions or indemnity to cover the compensation paid.

The reasoning revealed in those words was approved by the Judge in this case too as he outlined the benefits for those levy payers that fund FSCS in allowing the FSCS to pursue recoveries that appear reasonably possible and cost-effective. He stated that such pursuit of assigned claims by FSCS would be likely to be welcomed by innocent levy payers who would be presumed to rather see the costs of compensation paid by the scheme falling on third parties whose culpable acts and omissions had led or contributed to the claims in respect of which such costs arose. As claims on the FSCS continue to mount in the current climate for retail financial services and its funding costs grow in consequence, there will not be many regulated firms in the industry which bear those costs who will disagree with the Judge’s reasoning and decision on these preliminary issues. Corresponding author Joanna Gray can be contacted at: [email protected]


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Court of Appeal dismisses appeal on admissibility of FSA material as evidence in Directors Disqualification Proceedings Joanna Gray University of Newcastle upon Tyne, Newcastle upon Tyne, UK Abstract Purpose – The paper’s aim is to outline and comment on the Court of Appeal case: Secretary of State for Business Enterprise and Regulatory Reform v. Aaron and Others, October 2008. Design/methodology/approach – The paper outlines the facts surrounding the case and comments on the ruling. Findings – Lord Justice Thomas gave the judgment in this appeal, considering the admissible in disqualification proceedings. However, in relation to the Secretary of State’s attempt to rely in evidence on material in the FOS decision and the FSA final notice LJ Thomas ruled that that the implied exception to the strict rule of evidence in Hollington v. Hewthorn did not apply so as to allow their admission in evidence. Originality/value – The current market crisis has focused the attention of regulatory investigators around the world on the activities of major UK financial institutions in a number of jurisdictions in which they were active. Keywords Courts of appeal, Legal decisions, Insolvency Paper type Viewpoint

Secretary of State for Business Enterprise and Regulatory Reform v. Aaron and Others: Court of Appeal: Civil Division: Lord Justices Thomas, Keene and Buxton. Date of Judgment: 16 October 2008.


Facts This appeal was brought by the appellant from a decision of the Chancery Division in April 2008. An earlier preliminary decision in these proceedings has already been noted in Journal of Financial Regulation and Compliance, Vol. 16 No. 1, but the facts giving rise to the application under the Company Directors Disqualification Act 1986 of which this appeal forms part are noted again here. The disqualification proceedings arose following the insolvency of David M. Aaron (Personal Financial Planners) Ltd (the company). The financial services business carried on by the company had originally been carried on by an IFA partnership which was later incorporated to form the company in 2000. In June 2003, FSA had launched an investigation into the company’s activities which had led it to make certain findings of breaches of the regulatory regime applicable to the company’s business. Those breaches involved the mis-selling of structured capital at risk investment products (SCARPs) to investors. In December 2003, the Financial Ombudsman Service (FOS)

had made certain findings resulting in a decision from it which went against the company and in favour of an investor complainant concerning a direct offer SCARPs sale. The company went into administration in 2003. Investor claims (met by the Financial Services Compensation Scheme) amounted to some £11.9 million. The secretary of state had brought proceedings under the Company Directors Disqualification Act 1986 (CDDA) against three individuals, who were now who the appellants in this appeal, but who had been chairman and chief executive, investment director, and technical director of the company. The secretary of state alleged that the appellants were unfit to be concerned in the management of the company (pursuant to Section 6 CDDA) insofar as they had breached fiduciary duties owed to the company in that they failed to avoid causing the company to mis-sell SCARPS and that mis-selling led to the company’s insolvency. The secretary of state had sought to prove this allegation by relying on a detailed expert report prepared for use in the disqualification proceedings. This report had been prepared by an expert (Mr Jeremy Kaye) and the investigations team within the Insolvency Service of (the responsible agency for investigating and bringing company directors’ disqualification proceedings), described the rationale for obtaining this report as being to “test the findings of the FSA and FOS” and also make any additional findings as to aspects of the directors’ conduct which might attract criticism or deserve consideration. Action The appellants had objected in the original proceedings to use of that report, arguing that it was inadmissible since it contained matters which went to opinion rather than fact and pre-empted findings as to their fitness or otherwise to be involved in the management of a company when those issues were for the court properly to address and resolve in trial of the disqualification proceedings. A Deputy Judge of the Chancery Division had ruled in June 2007 that the FSA report was admissible as expert evidence only to the extent that it addressed “the nature of [the SCARPS] in question and the investment risks they pose” and that therefore the secretary of state should file a revised affidavit which would serve as expert evidence on the issue he had identified but would not be any more wide ranging or fuller than was needed for that. The secretary of state swore a fresh affidavit, but exhibited to it and referred to within it were the FSA’s investigation report into the company, and the FSA final notice and FOS decision relating to the company. The appellants challenged that affidavit too and requested that the secretary of state’s evidence omit all reference to FSA’s opinions or its findings of fact and conclusions expressed in its report or its final enforcement notice. The Chancery Division Deputy Judge before whom that application came ruled in April 2008 that all the FSA material exhibited in the secretary of state’s affidavit was admissible in the CDDA proceedings and the appellants now appealed from his decision to the Court of Appeal. Decision Lord Justice Thomas gave the judgment in this appeal and the other two Lord Justices expressed themselves to be in agreement with him. He considered the admissibility in evidence in CDDA proceedings of the FSA Report as a separate issue from that of the FSA Final Notice and the decision of the FOS.

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The admissibility of the FSA Report The FSA Report contained statements of what the FSA investigators had been told by witnesses, facts found by the FSA Investigators from the interviews they had conducted and the enquiries they had made and their conclusions in relation to the conduct of the company’s by the appellants, especially as regards risk assessment, mis-selling and breaches of FSA rules and principles. Lord Justice Thomas pointed out that the Civil Evidence Act 1995 would normally mean that the statements of what witnesses had told the FSA investigators were admissible, despite being hearsay. However, he also pointed out that the findings of fact and conclusions of the FSA investigators would normally not be admissible following the rule established in the decision of Hollington v. Hewthorn [1943] 1 KB 587 as they amounted to findings in other proceedings. At the core of the dispute about the admissibility of this FSA material was the scope of an implied exception to the strict rule in Hollington v. Hewthorn that had been developed in subsequent case law. That implied exception made admissible in court certain material produced as a result of a statutory scheme of investigation. The secretary of state argued that this implied exception applied so as to render the FSA investigators’ findings of fact and conclusions admissible in these disqualification proceedings but the appellants contended that the implied exception did not have that effect and had applied only to hearsay evidence – how dealt with and rendered admissible by the Civil Evidence Act 1995. In order to determine this issue Lord Justice Thomas analysed carefully all the case law that had developed and applied the implied exception to the rule in Hollington v. Hewthorn and concluded that it did apply in these circumstances so as to make the FSA Report admissible in disqualification proceedings: [I]t is it is clearly established that in disqualification proceedings whether brought under s.8 or under s.7 for an order under s.6 that there is an implied exception to the strict rules of evidence on hearsay evidence, opinion evidence and the rule in Hollington v Hewthorn. This was developed from the scheme of the Companies Acts on the basis that Parliament must have intended that a court should have regard to the materials produced under clear statutory procedures on which the secretary of state had relied in bringing the proceedings. There was no real disadvantage to a director. It was no more than prima facie evidence and the director was entitled to adduce evidence to contradict the findings and conclusions in the report. The court would reach its own conclusions.

Although it is no longer necessary to rely on the implied exception in relation to hearsay evidence, it is still necessary to do so in relation to findings of fact and conclusions in the report so long as the rule in Hollington v. Hewthorn remains good law. The principle of the statutory scheme under the Companies Acts, although broadened to include provisions of [the Financial Services and Markets Act], remains the same and the reasons for the implied exception remain valid. On an examination of the rationale for the decision in Hollington v. Hewthorn and the Law Reform Committee’s reasons for recommending its retention in civil proceedings, it is clear that the exception does not offend the underlying purpose of the rule. It is clear from the decisions to which I have referred that the implied exception has been developed in the context of the specific rules relating to disqualification and not in the context of rules pertaining to the use in subsequent litigation of a decision in prior litigation where the issues on which evidence is required in each of the sets of proceedings are

delineated by pleadings. The primary objective of the implied exception is to put before the court material obtained under the statutory scheme on which the secretary of state relied in making his decision and which forms the basis of the case against the defendant. It enables the defendant to know the case made against him and to put in the materials on which he relies in response. In my view, there is good reason to reaffirm not only the principle of the implied exception and its scope as extending to whatever is contained in the reports and other materials obtained under the statutory scheme, but also its eminent good sense in relation to disqualification proceedings such as this. To abrogate, the exception would be to render of no value a careful investigation, to put the public through the secretary of state to considerable and unnecessary expense and to cause significant delay. Save by making the task of the secretary of state more difficult, slower and expensive (with the consequent advantage that would provide to such defendant directors), it cannot sensibly be argued that the admission of such evidence causes any disadvantage to the defendant directors. It is plainly relevant evidence which a judge can and should take into account with all the other evidence in the case, giving it such weight as it deserves in the context of all the other evidence adduced. It was suggested on behalf of the defendant directors that the directors would be condemned on the basis of the opinion of third parties and not of the court determining the matter. I cannot accept that submission as having any semblance of reality. A judge of the Chancery Division will receive all the evidence, including the FSA report and the evidence for the defendants. It is, with respect, absurd to suggest that a judge of the Chancery Division who tries this case will not make up his or her own mind but will meekly follow or be influenced by the views of the FSA investigators. In my view, to exclude the FSA report would be to cause injustice by bringing about further delay and expense in these proceedings. There is fortunately no need to do so as the scope of the implied exception is clear. I would therefore uphold the decision of [the Chancery Division] on the main issue. The admissibility of the FOS decision and the FSA final notice However, in relation to the secretary of state’s attempt to rely in evidence on material in the FOS decision and the FSA final notice, Lord Justice Thomas ruled that that the implied exception to the strict rule of evidence in Hollington v. Hewthorn did not apply so as to allow their admission in evidence. He put it thus: I cannot see any reason to hold that anything relied on by the secretary of state is admissible in disqualification proceedings; the rationale for relying on the reports and other material fits into the statutory scheme, but there is nothing to suggest that the secretary of state can go outside this scheme. If he could, it would difficult to see what limit there could be to the materials relied on. There is also good sense in restricting the material relied upon to material produced through the statutory scheme for investigation; this is understood by everyone and the procedure clear. Moreover, a report or other material produced in this way can readily be distinguished from a decision in an adjudicative process (such as the decision of the FOS or the Final Notice) where the decision maker is deciding a matter between two parties.

Since such material is not analogous to the investigative material in the FSA Report prepared under a statutory scheme of investigation, it falls out with the exception to the strict rule of non-admissibility and so to this extent he did not uphold the decision of the Chancery Division.

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Comment It is possible to detect in the tone and tenor of Lord Justice Thomas’ judgment some slight frustration with these elaborate preliminary arguments about the extent to which the secretary of state’s evidence contained material that related to the company’s compliance with FSA regulation. For as a practical matter, he did not order excision or redaction of any parts of the documents on which secretary of state sought to rely. He pointed out the fact the costs consequences of so doing and stated that it was quite usual for a trial judge simply to ignore inadmissible parts of a document in reaching his conclusions. He makes an interesting more general point which occurred to him as a result of his consideration of the use made by the Courts of reports of Singapore Government Inspectors in the disqualification proceedings following the collapse of Barings Bank: It may be that in a diverse regulatory system within the UK and in a globalised financial and banking services industry, it is necessary to rely on investigative reports carried out by other regulators or under statutory authority in other states and that by analogy, such material can be relied on in disqualification proceedings. That was the effect of the decision in Barings and, although the point does not arise on the present appeal, I accept that an argument can be made along those lines and the merits of the argument can be decided when it arises, unless Parliament takes the preferable course of amending the CDDA.

The current market crisis has focused the attention of regulatory investigators around the world on the activities of major UK financial institutions in a number of jurisdictions in which they were active and, as those overseas regulatory and statutory investigations conclude and report if CDDA disqualification proceedings are subsequently taken here in relation to the stewardship of those institutions then this issue may well arise and fall to be resolved directly. Corresponding author Joanna Gray can be contacted at: [email protected]


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