Asian Financial Markets

Journal of

Financial Regulationand Compliance Asian financial marketsGuest Editors: Kevin Keasey and Charlie Cai

Volume 17 Number 1 2009

ISSN 1358-1988

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Access this journal online __________________________ 3

Editorial advisory board ___________________________ 4

Guest editorial ____________________________________ 5

Chinese investment goes global: the China InvestmentCorporationCharlie Cai and Iain Clacher ______________________________________ 9

Japan: the banks are back! Or are they?Maximilian J.B. Hall _____________________________________________ 16

Multinational banking in China after WTO accession:a surveyChen Meng ____________________________________________________ 29

An overview and assessment of the reform of thenon-tradable shares of Chinese state-ownedenterprise A-share issuersPaul B. McGuinness _____________________________________________ 41

Journal of FinancialRegulation andCompliance

Asian financial markets

Guest EditorsKevin Keasey and Charlie Cai

ISSN 1358-1988

Volume 17Number 12009

CONTENTS

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Market risk disclosure: evidence from Malaysianlisted firmsRadiah Othman and Rashid Ameer_________________________________ 57

LEGAL COMMENTARYExtent to which financial services compensationscheme can pursue claims assigned to it by investorswhom it has compensatedJoanna Gray ___________________________________________________ 70

Court of Appeal dismisses appeal on admissibility ofFSA material as evidence in DirectorsDisqualification ProceedingsJoanna Gray ___________________________________________________ 76

CONTENTScontinued

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Journal of Financial Regulation andComplianceVol. 17 No. 1, 2009p. 4#Emerald Group Publishing Limited1358-1988

EDITORIAL ADVISORY BOARD

Professor Mads AndenasDepartment of Law, University of Leicester, UK

Paul ArlmanFormer Secretary General of Federation of European StockExchanges, The Hague,The Netherlands

Professor Mukul G. AsherLee Kuan Yew School of Public Policy, National Universityof Singapore, Singapore

Dr John AshtonSchool of Management, University of East Anglia, UK

Graham BishopDirector of Grahambishop.com, East Sussex, UK

Professor Dr David Bland OBEFormer Director General of the Chartered InsuranceInstitute, London, UK

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

Richard BurgerSolicitor, Reynolds Porter Chamberlain LLP, London

Andrew CampbellReader in International Business Law, University of Leeds,UK

Professor Riccardo De LisaUniversity of Cagliari, Italy

Jos de WitAdvisory Board Member, Association of Certified Anti-Money Laundering Specialists,The Netherlands

Professor Joshua DoriyePrincipal of the Institute of Finance Management, Dar EsSalaam, Tanzania

Professor Robert FaffDepartment of Accounting and Finance, Faculty ofBusiness and Economics, Monash University, Australia

Michael Foot CBEChairman Promontory Financial Group (UK) Ltd, London,UK

Professor Charles GoodhartProgramme Director of Regulation and Financial Stability,Emeritus Professor of Banking & Finance, London Schoolof Economics, UK

Professor Max HallDepartment of Banking, Financial Markets andInstitutions, Loughborough University, UK

Professor Jenny HamiltonUniversity of Strathclyde Law School, UK

Professor David HillierDepartment of Accounting and Finance, Leeds UniversityBusiness School, The University of Leeds, UK

Professor Allan HodgsonAmsterdam Business School, Universiteit van Amsterdam,The Netherlands

Dr Robert HudsonDepartment of Accounting and Finance, Leeds UniversityBusiness School, The University of Leeds, UK

Jonathan LevinPartner, Reed Smith LLP, USA

Professor David T. LlewellynDepartment of Banking, Financial Markets andInstitutions, Loughborough University, UK

Professor Eva LomnickaSchool of Law, King’s College, University of London, UK

Dr Oonagh McDonaldVisiting Fellow at the International Institute of Bankingand Financial Services

Professor Paul B. McGuinnessChairman of Department of Finance, Chinese University ofHong Kong, Hong Kong

Walter MerricksChief Ombudsman, Financial Ombudsman Service, UK

Professor Paolo MotturaProfessor of Financial Markets and Institutions, UniversitaLuigi Bocconi, Italy

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

Dr Chizu NakajimaDirector of the Centre for Financial Regulation, CassBusiness School, City University, UK

Professor Michael OngDirector of Finance Programme, Stuart Graduate School ofBusiness, Illinois Institute of Technology and FormerExecutive Vice President and Chief Risk Officer, CreditAgricole Indosuez, New York, USA

Professor Julio PindadoDept. Administracion y Economia de la Empresa,Universidad de Salamanca, Spain

Professor Barry A.K. RiderFellow of Jesus College, Cambridge University, UK andExecutive Director of the Centre for InternationalDocumentation on Organised and Economic Crime

Joe RosenbaumPartner, Reed Smith LLP, USA

Dr Dalvinder SinghAssociate Professor of Law, University of Warwick, UK

David ThomasPrincipal Ombudsman for Banking, Financial OmbudsmanService, UK

Professor Robert WatsonDepartment of Economics and Finance, Durham BusinessSchool, Durham University, UK

Nick WeinrebGroup Head of Regulation, EuronextLiffe, London, UK

Professor James WilcoxKnuttschnitt Family Professor of Financial Institutions,Hass School of Business, University of California, Berkeley,USA

Dr Michael WolgastChief Economist and Head of Economics Department,German Insurance Association, Berlin, Germany

Professor Mike WrightCentre for Management Buy-Out Research, NottinghamUniversity Business School, UK

Dr Zhishu YangSchool of Economics and Management, TsinghuaUniversity, Beijing, PR China

Guest editorial

The editorial for this issue of JFRC comes at a very interesting time and is split into twoparts. The first part examines the credit crunch and considers the impact on regulationand compliance. The second part introduces this special issue on Asian FinancialMarkets.

The credit crunch – more to come!In January 2003, I wrote an article titled “Bah humbug” (University of Leeds, IIBFSFocus 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 theunlucky few?

We, of course, now know the answer – the “age of financial irresponsibility” hasalmost 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 backof a “wall of cash” from the Far East. Money has been provided in such quantitiesthat individuals, companies and countries have eventually struggled to meetrepayments – this issue was heightened when money markets froze but we should notforget that any entity has a sustainable level of debt and these were exceeded a longtime ago. The debt overhang problem has been exacerbated at the system level becausedebt has been repackaged to such a degree that nobody knows who is bearing whatand thus the fundamental plank of the financial system, trust, has been removed andwill take a long time to recover. The $55 trillion credit default swap market, which fewpeople understand or know where the risks truly lie, is just one example of the financialinsanity we are now facing.

To get a handle on the consequences of the crisis, let me look at the majorplayers – individuals, companies, banks, and governments.

IndividualsThey have borrowed to buy over priced properties, holiday homes, cars, flat screenTVs, etc. They have lived the “dream” on borrowed funds. House prices are nowdeclining, borrowing is more expensive and difficult to access, living costs have risensignificantly and not surprisingly, spending is being reined in! And this is all before thesignificant rises in unemployment that will occur in 2009 and 2010. In short, many willhave to significantly tighten their belts and for some this is going to be a very painfuladjustment process. One imponderable is how far this financial stress will feed throughto pay demands given the increases in unemployment.

CompaniesWe have already seen significant distress in the property, construction, car and retailsectors but this is just the start of the mounting pressures. All indicators point to asignificant tightening of the corporate sector, with increased numbers of insolvenciesand redundancies. Many companies have been postponing their cutbacks, hoping for

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Journal of Financial Regulation andCompliance

Vol. 17 No. 1, 2009pp. 5-8

q Emerald Group Publishing Limited1358-1988

glimmers of light, but it now looks likely that many will action cost reduction processesthis winter.

Banks and other financial service organisationsOver the past couple of months, we have seen a lot of distress in the banking sectorsaround the world, with huge government bail-outs in many countries. Over the comingmonths, we will see more distress in hedge funds as they struggle to sell assets atrealistic values and raise further funds. Equally, we have not seen the last of thedistress in the insurance sector as the de-leveraging continues to unwind. Finally, thebanks will need further capital as they are forced, quite rightly, to strengthen theirbalance sheets. The consequence of this is that the availability of funds will continue tobe limited with an obvious impact on individuals and companies.

The GovernmentIf the above are not concerning enough, we have the past, present and future actions ofthe government to consider. In all kinds of ways, we have ended up with a veryunbalanced economy and society. First, there is the over reliance on the financial sectorthat 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 theimprovements which should have been achieved given the spending. Third, we havethe high taxation and borrowing levels which have paid for the ineffective spendingwith 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 topay for the mess. The appropriate response will be to have a judicious amount ofgovernment spending and tax cuts but to let the consumer and companies rebalancetheir activities in the face of a “normal” lending environment. Quite simply, we have tolearn to live within our means and this will not be a bad thing given issues with foodand the environment. More likely, however, is that the government will try to spend itsway out of the crisis by further borrowing. This will have a number of serious andlasting consequences. First, the public sector may well crowd out the private sector tothe long-term detriment of the UK as a global trading nation. Second, we will be merelydelaying the eventual adjustment of individuals and organizations to a sustainableborrowing environment and the cost will be even higher the longer it is avoided – wewill 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 thecurrent recession until the autumn of 2010 but the actions of the government will haveconsequences for many decades as we all struggle to pay for the mountains of debt andan increasingly, uncompetitive and unbalanced economy/society.

Given all of the above, the interesting question is what this all means for regulationand compliance? It is quite clear that there are going to be demands from governmentand 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 drivenat the national level? Second, how do we regulate complex financial productswhen 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?

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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 fromgiven that regulation and compliance has played such a second fiddle for so long?Finally, what role should academics play in forming the regulation and complianceagenda going forward? To my mind, we have to be a lot more vocal in our concerns andbe open to different research methodologies. For example, there is little doubt that theslice and dice model of shoveling risk around the globe and complex derivativeproducts both played their role in the present crisis and both suffer (along with a lot ofacademic finance) from the assumption that risk is largely exgonous to the partiesdirectly involved – which is clearly incorrect given recent events.

As an editor, I welcome explorative and agenda creating articles on regulation andcompliance.

Kevin Keasey

Asian special issueI have had the pleasure of assembling a special issue on Asian Banking and FinancialMarkets. Given the rise of Far Eastern economies as significant global players and thechanging landscape of global economic and financial markets, the timing of this issuecould not have been better. As the world economy continues to adjust to the creditcrisis, with consequences for all countries across the globe (witness manufacturingcompanies in China laying off thousands of workers as the rest of the world reins in itsspending), understanding different aspects of the Asian financial system is ever moreimportant.

To this end, and at the request of Kevin Keasey, the first article, by Iain Clacher andmyself, reviews the behavior and actions of the Sovereign Wealth Fund (SWF) – theChinese Investment Corporation (CIC). SWFs are an increasing feature of the globalfinancial system and their influence is likely to increase as global institutions(and countries) have to recapitalize; a good and recent example if this is Barclaysturning to the Royal Family of Abu Dhabi for significant funds. The article on CICdescribes the size and strength of SWFs and highlights the increasing freedoms ofCIC to play a significant role on the global stage.

The second and third articles are concerned with Japanese and Chinese bankingmarkets. We all know that Japan has suffered from its own banking and financialcrises for quite some time but there has been a suggestion that it is now out of thewoods. Maximillian Hall’s article suggests, however, a note of caution on low levels ofcore profitability and asset quality. None the less, he ends on an upbeat note statingthat Japanese banks are back on track. The next article by Chen Meng analyses howmultinational banks have accessed China post-WTO accession. From a base of anumber of interviews, Chen Meng, concludes that multinational banks need to be clearabout their strategic objectives and to be aware of the efforts needed to establishnetworks, client resources and human assets. However, this task has become moredifficult as a result of the credit crunch because regulators and market participants areboth more cautious of the “western banking models.”

The final two papers in this issue are concerned with the financial markets ofChina and Malaysia. Paul McGuinness examines the reform of the non-tradableshares of Chinese state-owned enterprises (SOEs) and shows there is little evidenceof significant stock disposals by the SOEs and notes that given the recent

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significant falls in the Chinese stock markets, the authorities have every incentive todampen large-scale share sell-offs. However, as a number of share restrictions are notrelaxed until 2009-2011, the full impact of the share reform in China will take some timeto be evidenced. The final paper in this issue investigates the market risk disclosurepractices of Malaysian listed firms. The findings indicated that Malaysian firms do notreport credit risk and there is, therefore, in these difficult financial times, a need toimprove risk reporting and achieve greater financial transparency.

Charlie Cai

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Chinese investment goes global:the China Investment Corporation

Charlie Cai and Iain ClacherUniversity of Leeds, Leeds, UK

Abstract

Purpose – The purpose of this paper is to provide a detailed overview of the China InvestmentCorporation (CIC) and its structure, investment activities and possible future investments.

Design/methodology/approach – This paper uses a case study approach and builds up a pictureof 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 beincreasingly important in global investment. The CICs investment strategy is evolving and becomingevermore sophisticated. As the fund grows this will result in increased demand for local financialservices and expertise and so where representative offices are located will impact on those financialcenters.

Research limitations/implications – Future research should expand the scope of the analysis toinclude other sovereign wealth funds and try to map out a comprehensive picture of sovereign wealtharound the world.

Originality/value – This is one of the first papers to look at sovereign wealth and is believed to bethe 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 sovereignwealthThe $200bn China Investment Corporation (CIC) was established in 2007 and iscurrently the 6th largest sovereign fund in the world by total assets. However, since itsinception the fund has been controversial and the focus of much of the ongoing politicaldebate about the nature of sovereign wealth fund investments. However, from Table Iit is clear that the Abu Dhabi Investment Authority is the largest sovereign fund withtotal assets of $875bn. Of the top ten sovereign wealth funds, 70 per cent are from oilrich nations while the other 30 per cent are funded from non-commodity sources.Interestingly, the three funds that have large non-commodity surpluses are theAsian funds.

To put Asian sovereign wealth into a wider context, it accounts for approximately24 per cent of the total value of the top ten sovereign wealth funds. With total assets ofapproximately $638bn, Asian sovereign wealth is considerably less than theAbu Dhabi Investment Authority ($875bn). Further, the size of CIC relative to the totalvalue 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

The current issue and full text archive of this journal is available at


This paper is based on a thematic case study that the authors wrote for a report on AsianFinancial Centres for the City of London, The Future of Asian Financial Centres – Challengesand Opportunities for the City of London, October 2008.

Chineseinvestment goes

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Vol. 17 No. 1, 2009pp. 9-15


DOI 10.1108/13581980910934009

surpluses from oil production. However, it has been estimated that by 2015 sovereignwealth could amount to as much as $12 trillion with up to 50 per cent of these fundsbeing in Asia (Morgan Stanley Research, 2007). In line with such projections, CIC isexpected to receive more funding from the Chinese Government in the future with someestimates of the total value of the fund increasing to $300bn (FT.com, 2007).

CIC’s current investments and strategyThe initial foreign investments that CIC has made were almost exclusively in large USfinancials, namely, Blackstone ($3bn), Visa ($200 m), Morgan Stanley ($5bn) (Table II).These investments despite being substantial have mixed success. Since investingin Visa the share price has risen by 30 per cent while shares in Blackstone andMorgan 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 theBlackstone 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 beenspectacular. Just six months after listing the average return on the IPOs of the newlylisted Chinese banks was 74.3 per cent[2]. The Chinese experience of IPO investmenthas been of huge returns and so large US IPOs must have appeared particularlyattractive and a sound initial foray into international investment.

Fund RegionAssets($bn) Founded Source

Abu Dhabi Investment Authority Middle East 875 1976 OilGovernment of Singapore Investment Corporation Asia 330 1981 Non-commodityNorwegian Government Pension Fund Europe 322 1990 OilSaudi Arabia (various) Middle East 300 NA OilKuwait Investment Authority Middle East 250 1953 OilChina Investment Corporation Asia 200 2007 Non-commodityStabilization Fund of the Russian Federation Europe 127 2008 OilTemasek Holdings Asia 108 1974 Non-commodityQatar Investment Authority Middle East 50 2005 OilAlgeria North Africa 42 2005 OilTotal 2,604

Note: The table has been updated by the authors to include the newly established Stabilization Fundof the Russian FederationSource: Morgan Stanley Research (2007)

Table I.Top ten sovereign wealthfunds

Company name Industry Percentage holding (per cent) Value $bn

Blackstone Financial 10 3.0Visa Financial 2.5 0.2Morgan Stanley Financial 9.9 5.0JC Flowers Financial 80 4.0Veolia Environment SA Environmental services 1.5 0.3

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

Table II.CIC internationalinvestments

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However, the more recent investment in Morgan Stanley by CIC suggests an evolvinginvestment strategy. As a result of the losses incurred from investment in sub-primemortgages many banks have sought finance from sovereign wealth funds to helpre-capitalise their balance sheets. Citigroup, having incurred some of the highest losses,approached China Development Bank (CDB) for investment. However, as a state runbank CDB had to seek government approval for the deal and requested three days toreach a decision. At the same time, the Abu Dhabi Investment Authority was in talkswith Citigroup and was able to invest immediately and CDB lost out on the deal. Asresult of CDB losing out on the Citigroup investment, when CIC was approached byMorgan Stanley the deal went through without the lag that hampered theCDB/Citigroup deal. The fund is therefore making investments more autonomouslyfrom the central government in China (Financial Times, 2007).

Further, CIC has also started to change the structures of the deals that they areundertaking. CIC has undertaken a joint venture with JC Flowers, a US private equityfirm, to launch a new $4bn private equity fund that will focus on investments in USfinancial assets. As part of the deal CIC will become a limited partner in the newprivate equity fund providing about 80 per cent of the capital with JC Flowersinvesting 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 whiledeals of this nature usually only require the private equity firm to inject around 1-2per cent. In structuring the deal this way, CIC incentives and binds JC Flowers to thedeal as the private equity firm will bear more of the risk from any investments that itmakes[3].

As part of its investment strategy going forward CIC has also stated that the fundwill be moving away from financials into other markets (Financial Times, 2007). To thisend, CIC has acquired a 1.5 per cent stake in Veolia Environment SA ($275 m), thebiggest water company in the world. This shows that the strategy of CIC is alreadychanging as it is diversifying its holdings away from financials. However, thisinvestment has moved the fund into a more politically sensitive area, namely utilitiesand investments by sovereign funds in such strategic assets raises protectionistsentiments in governments around the world. Consequently, the fund may find thatsome deals are more difficult to execute because of resistance by governments andregulators around the world.

The international politics of CIC investmentAs a government backed investment fund CIC will clearly receive considerableattention from the government and regulators of the countries in which they areinvesting. To date the only country that has openly stated that it is not opposed toinvestment by CIC is the UK. The response of the UK has been that investments in UKcorporations 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 vocalin their opposition to sovereign wealth funds. This protectionist stance has been mostvocal in the USA, Germany and France all of whom have explicitly stated that they willact 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 fundsinvesting (France Announces Sovereign Wealth Fund, 2008).

The USA in particular has taken a very strong protectionist stance and in this isespecially true with respect to CIC. This was highlighted in a report produced forCongress only six months after CIC was created. The report suggested a number ofpolicy responses to the emergence of CIC. These include a global code of conduct forsovereign wealth funds, a step that has also been advocated by the EU TradeCommissioner, Mandelson (2008). More provocatively, the report also suggests that USlaws might be redrawn to limit where and in what industries sovereign wealth fundscan 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 strategicassets being brought under the proxy control of a foreign government isunderstandable. As a result, the International Monetary Fund (IMF) and theOrganisation for Economic Co-operation and Development (OECD) are pressing for aglobal code of conduct for sovereign wealth funds to increase transparency and makeclear their objectives and governance.

To this end, the International Working Group of Sovereign Wealth Funds, which ismade up 26 sovereign wealth funds including CIC, reached a preliminary agreementon a draft code of principles and practices on 2 September 2008. These generallyaccepted principles and practices for sovereign wealth funds cover governance,accountability and investment practice for sovereign wealth funds. This is howeveronly 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 hasexplicitly objected to the implementation of such a code. In an interview on UStelevision, the General Manager of CIC, Gao Xiqing, insisted that it will not seek controlof any of its investment targets and so believed an international code of conduct isunnecessary.

The domestic politics of CIC investmentMost of the current media attention on CIC focuses exclusively on how the fund investsand the relationships that CIC has with the target company’s government. CIC ishowever a state backed fund, and must also therefore be sensitive to domestic policyconcerns. This relationship has already impacted upon the emergent strategy of CICwith 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 buytheir banking arm, Dresdner Bank (Sueddeutsche Zeitung cited in Reuters News (2008)).However, CIC subsequently walked away from the deal citing investment risk andpolitical problems. This is thought to be because relations between Germany and Chinahave cooled since the German Chancellor, Angela Merkel, met with the exiled TibetanLeader, the Dalia Lama. As a state back fund CIC are by proxy representing theinterests of the Chinese Government and so CIC walked away from the deal as this mayhave led to political difficulties at home (Reuters News, 2008). Consequently, CIC maybe unlikely to invest in countries/regions where the political reaction is hostile or wherediplomatic relations with the Chinese Government are strained.

Although CIC is viewed as a strategic investment vehicle it must also generate areturn on its investments. The need to be successful and make sound investments is

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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 onlybecome reality if the fund performs well and makes sound investments over thelong-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 popularawareness of CIC’s activities in managing the country’s reserves and any significantlosses are likely to generate large amounts of adverse publicity. This has beenapparent from the Blackstone investment. Having made significant losses on theinvestment in Blackstone CIC was widely criticised in the Chinese media. Many inChina viewed the investment as hasty, badly timed and a demonstration of CIC’sinexperience in appraising investments and their associated risks (Beijing Review,2008).

Implications for global financial marketsOne impact that CIC will have on financial markets in the near future is deciding whowill manage their foreign assets. A number of large international companies have beenrumoured to be in the running including, Goldman Sachs, Morgan Stanley, UBS, andInvesco. There are also two Chinese companies who have submitted bids. One is ChinaInternational Capital Corporation, who successfully tendered to manage a portion ofthe National Social Security Funds international investments in a joint venture withGoldman Sachs. The other is China Life, an insurance company, in a joint venture withFranklin Templeton, an US asset management company (Nangfang Daily, 2008a).The tender process, however, has not been without some controversy as the design ofthe asset allocation plan was given to exclusively to Morgan Stanley, a company inwhich CIC is the second largest shareholder. Some commentators have expressedconcerns that Morgan Stanley (2008) may weight the plan towards investments thatreflect the expertise of the firm.

Further, the fund is already showing signs of being an influential investor in globalfinancial markets. Most recently, HSBC’s (Hong Kong) shares jumped 4.1 per cent, theirbiggest one day rise in four months, on rumours that CIC was talking with thecompany about investing. The Chairman of HSBC, Stephen Green, met with CICseveral times and one of the rumours was that CIC would buy shares in HSBC on theopen market. Investors viewed the deal as being good for HSBC with one analystcommenting (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 growthof CIC will result in a huge demand in financial services. Recent examples of firms thathave benefited from CIC outsourcing projects are McKinsey, a management consultingfirm, who assisted in the organisational design in the initial stages of the setting up ofCIC. Morgan Stanley has also benefited as CIC appointed them to be the lead consultanton formulating CIC’s global asset allocation plan.

The importance of CIC setting up representative offices in global financial centers isalso clear. As a consequence, there has been considerable speculation and the potentiallocation of these offices as the financial centers where CIC locates to will benefit fromthe funds demand for local financial services and expertise.


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Most recently, there has been considerable media coverage with regards to CICsetting 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 wouldbe the logical place for CIC to be based. CIC, however, is still currently located inBeijing with most other Chinese Government bodies and has yet to set up a presencein China’s domestic financial centre, let alone in global centres.

ConclusionsThe growth in sovereign wealth globally has resulted in a significant amount of debateas to its role and the underlying motives for the investments that are made by thesefunds. This is evident from the intense media scrutiny and extensive debate onsovereign wealth in political arenas such as the US Congress, the OECD, the IMF andthe EU. CIC has been the focus of much of this debate, especially in the USA, wherethere have been calls for protection of key strategic assets (China’s Sovereign WealthFund, 2008). This is despite CIC being less than one-year old and accounting for only asmall fraction of Asian and Global sovereign wealth.

CIC however has made a number of large high-profile investments, although withvarying success. From these deals however, it is clear that CIC’s investment strategy isevolving. The initial investments in the IPOs of Blackstone and Visa were driven bythe limited experience of Chinese IPOs which have been remarkably successful.However, their investments in Morgan Stanley and JC Flowers are a definite shift in thestrategy of the fund. The Morgan Stanley deal was completed with a high degree ofautonomy from the centre in China, and the JC Flowers investment imposed a uniquestructure on the deal. Further, the latest investment in Veolia Environment SA,the worlds largest water company, also highlights a move away from financials intomore (potentially controversial) strategic assets.

In the near future CIC will be appointing fund managers and possibly setting upinternational representative offices. This is going to have a large impact on the majorfinancial centres around the world where these tender bids are successful. Successfulbidders will be allocated substantial amounts of funds to manage and with this willcome 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 theactual 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 casestudy 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.

JFRC17,1

14

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 bankingsector 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 October2008).

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 FundsReaches a Preliminary Agreement on Draft Set Generally Accepted Principles andPractices – “Santiago Principles”, 2 September.

(The) Sunday Telegraph (2008), “CIC to invest in HSBC”, The Sunday Telegraph, 20 July.

Corresponding authorIain Clacher can be contacted at: [email protected]


global

15

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Japan: the banks are back!Or are they?

Maximilian J.B. HallDepartment of Economics, Loughborough University, Loughborough, UK

Abstract

Purpose – The purpose of this paper is to demonstrate how Japanese bank “performance” hasimproved markedly since fiscal 2003 but to caution against over-optimism.

Design/methodology/approach – The methodological approach adopted involves usingaggregate balance sheet data dating from around 1990 to identify the trends in industryperformance 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 adverseimpact on “performance”, as measured by the above-mentioned indicators, but, after fiscal 1992, theindustry’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, boththe industry and their supervisors are given advice as to which areas they need to focus on to improvefuture bank performance.

Originality/value – The paper clearly explains the nature of, and reasons for, the recentimprovement in Japanese bank performance whilst highlighting the areas on which they still have tofocus if they are to regain their former glory within the international banking community. It should beof 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. IntroductionApart from turning the tide on the non-performing loan (NPL) front, most performanceindicators at the end of fiscal 2002 (i.e. at end-March 2003) painted a fairly bleakportrait 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 agrowing share of core capital; and the sector was heavily exposed to equity risk, creditrisk and interest rate risk (IMF, 2003; Hall, 2006). At end-March 2004, however, five ofthe top seven banking groups (UFJ Holdings and Resona Holdings – Resona Bank hadto be rescued by the Government in May 2003 – were the odd ones out) posted netprofits for the first time in three years, with the sector returning to overall profitabilityin fiscal 2004. And the following year, record profits were recorded by the bankingindustry. This remarkable turnaround, together with the associated reduction infinancial fragility, are analysed in more detail below, together with the formidableproblems still besetting the sector.

The paper is structured as follows. The next section reviews the structure of theJapanese banking sector as it stood at end-March 2007 following further consolidationand rationalisation. Section 3 analyses the latest trends in bank “performance”, interms of profitability, asset quality and capital adequacy. Section 4 looks at thechallenges still facing the sector. And Section 5 summarises and concludes.



The financial support of the Daiwa Anglo-Japanese Foundation is gratefully acknowledged.

JFRC17,1

16

Journal of Financial Regulation andComplianceVol. 17 No. 1, 2009pp. 16-28q Emerald Group Publishing Limited1358-1988DOI 10.1108/13581980910934018

2. The structure of the Japanese deposit-taking sectorAs shown in Table I, at end-March 2007 there were over 200 banks proper operating inJapan with more than 1,500 cooperative-type institutions also active as deposit-takers. Theformer group comprised six city banks, 64 regional banks, 46 second association regionalbanks, 65 foreign banks, 21 trust banks and ten “others”. Continued consolidationamongst 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 aseparate sub-group. (For a discussion of the operations performed by the variouscategories of bank and co-operative, see Japanese Bankers’ Association (2001)).

3. Recent trends in bank performance3.1 ProfitabilityAs can be seen from Table III, the banking industry’s performance was dire betweenfiscal 1995 and 2002, largely as a result of the collapse of Japan’s asset price bubble andstagnation in the real economy. Indeed, during this period, net losses were recorded foreach of the years 1995, 1997, 1998, 2001 and 2002. Whilst lending margins and grossprofits remained fairly stable, net operating profits were negative from fiscal 1993onwards 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-marketaccounting also meant that, after fiscal 2001, banks were unable to boost profits byrealising capital gains.

With the pick-up in the real economy (albeit at a sluggish pace) from 2003, largelydue to export-led recovery because of a low-exchange rate, and knock-on effects forcorporate Japan and the stock market, the banking sector’s fortunes began to improve.

Banksa City Banks (6)Regional Banks (64)Second Association of Regional Banks (46)Foreign Banks (65)Trust Banks (21)b

Others (10)c

Cooperatives Shinkin Central BankShinkin Banks (287)Shinkumi Federation BankCredit Cooperatives (168)Rokinren BankLabor Banks (13)Norinchukin BankCredit Federation of Agricultural Cooperatives (41)Agricultural Cooperatives (835)Credit Federations of FisheryCooperatives (31)Fishery Cooperatives (181)

Notes: Figures in parentheses represent the number of institutions in each category operating at1 April 2007. aIncluding 10 bank holding companies; bincluding foreign-owned trust banks; cincludingthe Second Bridge Bank of Japan and the Resolution and Collection CorporationSource: Japanese Bankers’ Association (2007, p. 1)

Table I.Categorisation of private

depository institutionsoperating in Japan

Japan: the banksare back!

17

Although the sector, overall, did not return to profitability until fiscal 2004 [1], with themajor banks reporting positive net income for the first time in four years and theregional 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. Continuedeconomic recovery during 2004/2005 [2], a return to positive bank lending [3] andcessation of deflation [4] contributed to a record profits performance by the sector infiscal 2005 as loan losses fell dramatically and a recovery in stock prices allowed forthe realisation of capital gains again. Fiscal 2006 saw the industry reporting veryhealthy [5], if slightly lower – because of a slight decrease in interest margins, a fall innon-interest income and an increase in credit costs associated with exposures to theconsumer finance industry as a result of changes in the law relating to the so-calledusurious (although the legal maximum was retrospectively cut to 29.2 per cent,

Merged entities Date of merger New entity formed Latest developments

Dai-Ichi Kangyo Banka,Fuji Banka, IndustrialBank of Japanb, MizuhoTrustc (jointly owned)

September 2000 Mizuho Holdings,comprising: Dai-IchiKangyo Banka; FujiBanka; Industrial Bank ofJapanb; Mizuho Trustc

Mizuho Holdings(renamed MizuhoFinancial Group in March2003), comprising (atApril 2002): MizuhoBanka; Mizuho CorporateBanka; Mizuho Trustc

Sakura Banka, SumitomoBanka

April 2001 Sumitomo Mitsui,Banking Corporation

Sumitomo MitsuiFinancial Group,comprising (at December2002): Sumitomo MitsuiBanking Corporationa

Bank of TokyoMitsubishia – TokyoTrustc, MitsubishiTrustd, Nippon Trustd

April 2001 Mitsubishi TokyoFinancial Group,comprising: Bank ofTokyo-Mitsubishia;Mitsubishi Trustd;Nippon Trustd; TokyoTrustc

Mitsubishi TokyoFinancial Group,comprising (at October2001): Bank ofTokyo-Mitsubishia;Mitsubishi Trustd

Sanwa Banka, TokaiBanka – Tokai Trustc,Toyo Trustd

April 2001 UFJ Holdings,comprising: SanwaBanka; Tokai Banka;Toyo Trustd; TokaiTrustc

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

Daiwa Bank Holdings,comprising (at December2001): Daiwa Banka;Kinki Osaka Banke; NaraBanke; Asahi Banka;Asahi Trustc

March 2002(effective October2002)

Resona Holdings,comprising: DaiwaBanka; Asahi Banka;Kinki Osaka Banke; NaraBanke; Daiwa Trustd

Resona Holdings,comprising (at March2003): Resona Banka;Saitama Resona Banka;Kinki Osaka Banke; NaraBanke; Resona Trustd

Mitsubishi TokyoFinancial Group UFJHoldings

October 2005(effective January2006)

Mitsubishi UFJ FinancialGroup

–

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

Table II.Consolidation amongstthe major Japanesebanks, 2000-2006

JFRC17,1

18

Fin

anci

aly

ear

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

Len

din

gm

arg

in((

i))

7.1

8.9

9.8

9.2

9.7

10.8

10.8

10.0

9.6

9.7

9.4

9.8

9.4

9.0

8.7

8.7

8.5

Oth

erre

ven

ue

((ii

))2.

62.

22.

52.

82.

13.

53.

63.

63.

12.

53.

03.

13.

64.

34.

65.

24.

3O

per

atin

gco

sts

((ii

i))

7.1

7.5

7.7

7.8

7.8

7.8

8.0

7.9

7.5

7.3

7.1

7.0

7.0

6.7

6.4

6.5

6.5

Gro

ssp

rofi

t((

iv)¼

(i)þ

(ii)

-(ii

i))

2.6

3.5

4.5

4.3

4.0

6.5

6.4

5.7

5.2

4.9

5.3

5.9

6.0

6.6

6.9

7.4

6.3

Loa

nlo

ss(v

)0.

81.

02.

04.

76.

213

.37.

413

.413

.56.

36.

69.

47.

06.

14.

22.

01.

7N

etop

erat

ing

pro

fit

((v

i)¼

(iv

)-(v

))1.

82.

52.

52

0.4

22.

22

6.8

21.

02

7.7

28.

32

1.4

21.

32

3.5

21.

00.

52.

75.

44.

6R

eali

sed

cap

ital

gai

ns

((v

ii))

)2.

00.

70

2.0

3.2

4.4

1.2

3.6

1.4

3.8

1.4

22.

42

4.1

0.6

20.

10.

50.

2N

etp

rofi

t((

vi)þ

(vii

))3.

83.

32.

51.

71.

02

2.4

0.2

24.

12

6.9

2.3

0.1

25.

92

5.1

1.1

2.6

5.9

4.8

Sources:

Jap

anC

ente

rfo

rE

con

omic

Res

earc

h(2

003)

and

Fu

kao

(200

7)

Table III.Profitability of the

Japanese banking sector,1990-2007 (¥ trillion)


19

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 exposuresto the consumer finance industry (i.e. loans to and investments in consumer financecompanies, consumer credit companies and credit card companies) and, for some, to theUS sub-prime market [6] (Bank of Japan, 2008).

3.2 Asset qualityThe trend in the Japanese deposit-taking sector’s “bad” (i.e. “risk management”) loansis clearly indicated in Table IV. Hitting a peak of ¥53 trillion at end-March 2002, it wasdown to ¥18.4. trillion by end-March 2007. In part, this reflects the success of theFinancial Services Agency’s (FSA) plan to force the major banks to halve their NPLratios between end-March 2002, when the combined ratio stood at 8.4 per cent, andend-March 2005. As demonstrated in Table V, the major banks’ combined ratio wasdown to 2.9 per cent by end-March 2005, with further declines taking it down to1.5 per cent by end-March 2007, a level maintained at end-September 2007, the latestdate for which figures are available (FSA, 2008). At 3.9 per cent, the latest figure for theregional 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 stilloperating with ratios substantially in excess of this figure. The performance duringfiscal 2007, however – as noted above – is likely to reverse this declining trendsomewhat, but hopefully only temporarily.

3.3 Capital adequacyDespite all groups of banks posting figures demonstrating compliance with capitaladequacy requirements, be they of the risk-adjusted type applied tointernationally-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 affairsmasked serious problems during the post-bubble era. As shown in Table VI: core capitalwas 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 insteady decline between 1994 and 1998 and again between 2000 and 2003, reflectinggyrations in the value of their securities; after 1998, DTAs represented a significantproportion of net capital; and, following capital injections by the Deposit InsuranceCorporation (DIC) towards the end of the century in an attempt to stabilise the bankingand financial sectors (Hall, 2006), from 1999 a significant chunk of core equity capitalwas held by the government reflecting the degree of “nationalisation” instituted by theauthorities. Since 2003, however, these problems have become less important. Therecovery 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 ofprivately-held net capital has increased since 2003 as banks have repaid some of theearlier DIC capital injections [8].

Notwithstanding these undoubted improvements in both the quality andquantity [9] of bank capital at a time when exposures to credit risk, interest rate risk

JFRC17,1

20

Date“Bad” loans outstanding

(¥ billion)Stock of specific provisions

outstanding (¥ billion)Estimate of “problem

loans to be disposed of”a (¥ billion)

End of March 1992 7,000-8,000b – –End of March 1993 8,400b – –End of March 1994 10,500b – –End of September 1994 13,300b – –End of March 1995 11,640b – –End of September 1995 38,086c 6,961 18,587d

End of March 1996 34,799e,f 12,530e 8,305e

End of September 1996 29,228 g,h 9,948 g 7,303 g

End of March 1997 27,900i,j 12,343i 4,685i

End of September 1997 28,078k,l 13,993k 4,348k

End of March 1998under “old” disclosurestandards 24,979 m,n NA NAUnder “new disclosure”standards 35,207 m,n 19,035 m 1,583 m,o

End of March 1999 38,656 14,802 NAEnd of March 2000 41,367p 11,500p NAEnd of March 2001 43,448q 10,039q NAEnd of March 2002 53,049r 10,375r NAEnd of March 2003 45,676r 8,569r NAEnd of March 2004 35,851 7,775 NAEnd of March 2005 25,840 6,384 NAEnd of March 2006 20,284 4,583 NAEnd of March 2007 18,354 4,297 NA

Notes: aThis figure represents an estimate by the Ministry of Finance of the scale of loans for which possible losses havenot been provided nor that are likely to be covered by collateral (i.e. loan losses considered “irrecoverable” and notprovided for). bMinistry of Finance estimate of “NPLs” for the 21 largest banks. Figures include claims againstcustomers who went bankrupt and claims on which interest payments were more than six months overdue due to thesuspension 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 reducedto below the ruling official discount rate) for the first time and now cover all Japanese deposit-taking financialinstitutions (i.e. city banks, long-term credit banks, trust banks, regional banks and co-operatives). dThe figure isinclusive of possible losses (estimated at ¥7,700 billion) resulting from exposure to the eight jusen companies. eThefigures exclude the Kizu Cooperative (with about ¥1,190 billion in problem loans), the Fukui Prefecture First CreditCooperative (¥2.6 billion), the Osaka Credit Cooperative (¥270 billion), and Taiheiyo Bank (¥330 billion). fThe figureexcludes 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 tojusen 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 CreditCooperatives (¥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 andco-operatives) at end of September 1996. iThe figures exclude the Hanwa Bank (with around ¥190 billion in problemloans), the Sanpuku Credit Cooperative (¥26 billion), and the Hanshin Labor Credit Cooperative (¥3.5 billion). jThe figureexcludes 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 forthe 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 whichthe lending bank(s) is extending help, estimated at ¥3,084 billion at end of September 1997 for all major banks (asdefined in note 10). mThe figures exclude the Hokkaido Takushoku Bank, Tokuyo City Bank, Kyoto Kyoei Bank, NaniwaBank, Fukutoku Bank, Midori Bank, and 32 credit companies whose assets and liabilities have been transferred to otherinstitutions. nThe figure excludes loans to borrowers to which the lending bank(s) is extending help, estimated at ¥2,015billion at end of March 1998 for all Japanese deposit-taking institutions. oThe figure was provided privately to me by theFSA. pThe figures exclude the Nippon Credit Bank. qThe figures include the Nippon Credit Bank but exclude the TokyoSowa Bank, Niigata Chuo Bank and bankrupted co-operatives. rThe figures exclude financial institutions which weredeclared bankruptSources: Hall (2000) and FSA (2007, 2008)

Table IV.The evolution of the

“bad” (i.e. “riskmanagement”) loans of

the Japanesedeposit-taking sector,

1992-2006


21

En

d-M

arch

2002

(per

cen

t)E

nd

-Mar

ch20

03(p

erce

nt)

En

d-M

arch

2004

(per

cen

t)E

nd

-Mar

ch20

05(p

erce

nt)

En

d-M

arch

2006

(per

cen

t)E

nd

-Mar

ch20

07(p

erce

nt)

Cit

yb

ank

s21

8,12

0(8

.7)

176,

690

(7.3

)11

8,49

0(5

.3)

64,6

30(3

.0)

40,6

50(1

.8)

35,0

90(1

.5)

Lon

g-t

erm

cred

itb

ank

s27

,420

(7.9

)4,

360

(5.8

)1,

860

(2.9

)1,

500

(2.4

)64

0(0

.9)

610

(0.7

)T

rust

ban

ks

38.3

10(9

.1)

25,7

50(6

.6)

17,6

70(4

.7)

9,47

0(2

.7)

5,66

0(1

.6)

5,74

0(1

.6)

Maj

orb

ank

s26

7,82

0(8

.4)

202,

440

(7.2

)13

6,16

0(5

.2)

74,1

00(2

.9)

46,3

00(1

.8)

40,8

30(1

.5)

Reg

ion

alb

ank

sI

107,

810

(7.7

)10

5,89

0(7

.6)

94,4

40(6

.8)

76,7

40(5

.5)

63,8

30(4

.4)

58,1

50(3

.9)

Reg

ion

alb

ank

sII

40,4

10(9

.0)

38,9

90(8

.9)

31,9

50(7

.5)

25,8

70(6

.3)

22,0

80(5

.3)

19,2

70(4

.5)

All

ban

ks

432,

070

(8.4

)35

3,39

0(7

.4)

265,

940

(5.8

)17

9,27

0(4

.0)

133,

720

(2.9

)11

9,74

0(2

.5)

Notes:

¥10

0m

/per

cen

t.A

sd

efin

edu

nd

erth

e“F

inan

cial

Rec

onst

ruct

ion

Law

”Source:

FS

A(v

ario

us)

Table V.Recent trends in banks’NPLs

JFRC17,1

22

(i)

(ii)

(iii

)(i

v)

(v)

(vi)

(vii

)(v

iii)

Per

iod

(en

d-M

arch

)C

ore

cap

ital

aM

ark

etv

alu

eof

shar

esh

eld

Boo

kv

alu

eof

shar

esh

eld

(¼

0.6(

(ii)

-(ii

i))b

)N

etca

pit

al(¼

(i)þ

(iv

))D

TA

Cor

eeq

uit

yca

pit

alh

eld

by

gov

ern

men

tP

riv

atel

y-h

eld

net

cap

ital

(¼

(v)-

(vii

i))F

1991

30.2

77.7

33.1

26.7

57.0

00

57.0

1992

31.3

56.4

34.5

13.1

44.4

00

44.4

1993

31.8

56.4

34.5

13.1

44.9

00

44.9

1994

32.3

61.9

36.5

15.2

47.5

00

47.5

1995

32.3

52.0

39.8

7.3

39.6

00

39.6

1996

27.9

64.3

43.0

12.8

40.7

00

40.7

1997

28.5

54.1

42.9

6.7

35.2

00

35.2

1998

24.5

50.8

45.7

3.1

27.6

00.

327

.319

9933

.747

.142

.72.

636

.38.

46.

330

.020

0035

.254

.544

.46.

141

.38.

16.

934

.420

0136

.744

.544

.30.

136

.87.

37.

129

.720

0229

.334

.434

.40

29.3

10.7

7.2

22.1

2003

24.8

23.2

23.2

024

.810

.67.

317

.520

0429

.028

.528

.50

29.0

7.2

8.9

20.1

2005

31.4

27.7

27.7

031

.45.

78.

123

.320

0637

.33.

222

.20

37.3

2.3

5.2

32.1

Notes:

aE

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003)

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(200

7)

Table VI.Aggregate capital held by

Japanese banks,1991-2007


23

and market risk (incurred through stock holdings) were also generally falling [10] –thereby reducing overall financial fragility – some questions remain about the capitaladequacy assessment regime. These are addressed in the next section.

4. Challenges still facing the Japanese banking sector4.1 ProfitabilityDespite the recent improvements in profitability noted in Section 3.1, which saw majorbanks achieving a return on equity (ROE) of 16 per cent in fiscal 2005 – almost on a parwith major US/EU banks – compared with a figure of over 7 per cent posted byregional banks, this has resulted mainly from the sharp reduction in credit costsenjoyed as a result of the reduced need to make allowance for loan losses once the NPLproblem came under control. This has led economists at the Bank of Japan to develop aprofitability measure that excludes volatile factors, such as credit costs, gains/losses onsecurities and corporate income tax payments. Their preferred measure (Hattori et al.,2007), is “core ROE”, where the above-mentioned volatile items are stripped out ofROE, 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 largediscrepancy between individual banks) are shown to have secured only a slightincrease – 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, thelimited increase in core ROE was due to net income increasing by only fractionallymore than equity. This, in turn, was mainly due to a fall in net interest income (the fallin 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). Theregional banks somewhat poorer performance reflected their slower growth innon-interest income for, whereas both groups of banks enjoyed increased fee incomefrom the sale of mutual funds and pension/insurance policies, the major banks alsoenjoyed significant contributions from the origination of syndicated loans and theprovision of commitment lines.

The above analysis highlights the main factors still adversely impacting on bankprofitability. For, although positive ROAs and ROEs are once again the norm, coreROEs are very low, both in absolute terms and relative to EU/G10 banks (Bank ofJapan, 2007, pp. 47-50), because of weak growth in interest income – due to anaemiccorporate loan demand and an inability to expand lending margins in a low nominalinterest rate and highly competitive environment – and, for many, limited success indiversifying away from traditional lending activities [11]. Moreover, attempts to raiseinvestment returns by diversifying away from stocks and bonds [12] (e.g. intostructured products – such as RMBs, including those originated in Japan – creditproducts and hedge funds) have been shown to be fraught with danger; witness thefallout from the sub-prime turmoil discussed earlier.

In the face of such difficulties, banks will need to try and boost profits earnt on theircore business by improving their management of credit risk [13], restraining theincrease in credit costs, raising lending margins and re-enforcing their fee-generatingbusiness (Hattori et al., 2007). Whilst the last two remedies will not prove easy in thecurrent market environment [14], especially for regional banks given the major banksincursion into their traditional territory and the growing importance of the Japan PostBank, the Post Office’s new banking arm [15], they are essential components of

JFRC17,1

24

an integrated strategy that should seek to identify comparative advantage and marketdemands 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 beused 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 realeconomy, to try to engineer a generalised recovery in land prices and to promote theefficiency and competitiveness of the Japanese banking sector throughderegulation [16]. Further rationalisation within the regional bank sector should alsobe encouraged as some highly inefficient operators still exist, protected by themonopolistic practices still evident within the prefectural system.

4.2 Asset qualityWhile 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 onexposures to the consumer finance industry and on sub-prime-related products are areminder of how quickly events can change. Risk management skills and policies mustbe up-rated if future losses on loans and investments are to be held to acceptable levels.

4.3 Capital adequacyNotwithstanding the recent increases achieved in both the quantity and quality of bankcapital noted in Section 3.3 above, a number of reservations remain concerning thecapitalisation of Japanese banks. With respect to compliance with the BIS “rules”, astricter interpretation would see: some of the banks’ loan loss provisions, currentlyclassified as general but which, in reality, are specific, being fully deducted fromcapital; a greater proportion of cross-shareholdings being deducted from capital (toovercome the problem of “double gearing”); and further restrictions being placed on theinclusion of DTAs in core capital. Moreover, a more realistic view needs to be taken bysome banks of the value of loan collateral and borrowers’ capacity to repay, as reflectedin NPL classifications and hence provisioning [17], a move which would further depletereported bank capital ratios.

5. Summary and conclusionsSince fiscal 2003, the “performance” of the Japanese banking sector has improvedmarkedly, in tandem with that of the real economy. Record profits were revealed infiscal 2005, with results for fiscal 2006 showing only a small fall from this peak,although results for fiscal 2007 were disappointing. Similarly, asset quality hasgenerally improved, with NPL ratios now well below the historic highs recorded atend-March 2002, and market risks now somewhat lower than when the IMF conductedits infamous “Financial Stability Assessment Programme” stress tests back in 2003.Moreover, bank capital adequacy has generally improved, with both “Tier 1” ratiosand overall, BIS risk-adjusted ratios (now Basel II compliant) typically approachinginternational norms and being comfortably in excess of regulatory requirements. Andthe quality of capital has also increased with less reliance now being placed on DTA asa source of capital.

Yet things are not as healthy as this image portrays. Core profitability, once volatilefactors such as credit costs are stripped from the figures, remains very weak, both in


25

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 tosee a generalised recovery. And diversification from traditional lending activities isstill limited, fee and commission income at the major banks, for example, accountingfor around only 20 per cent of operating income. Similarly, with respect to assetquality, exposures to the US sub-prime market have delivered investment losses forsome whilst exposures to the consumer finance industry since the passage oflegislation concerning usurious “grey loans” have caused nasty blips in both NPLratios and credit costs. Moreover, the issues surrounding continued “under-reserving”and regulatory tolerance of “double gearing” mitigate, to a degree, the successesachieved on the capital adequacy front. Overall, however, the Japanese banking sectorappears 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, ifnot yet by ROE! The continuing challenges faced in intensely competitive domestic andinternational markets are, however, well understood. And rising nominal interest ratesalong with improved risk management capabilities are likely to deliver increasingbenefits in the medium to long term.

Notes

1. Although Table III actually shows the sector returning to profitability in fiscal 2003 becauseof 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 toend-March 2006. By end-March 2008, the index had reached a ten-year high of 1.2 per centdue to rising food and energy prices but, stripping these items out, left a figure of only0.1 per cent (and the GDP deflator was still 21 per cent).

5. Assisted by the removal of the competitive advantages enjoyed by the Postal SavingsSystem and Postal Life-insurance through privatisation, and by the privatisation/scalingback 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-relatedproducts 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 majorbanks’ 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 2007of 49.8 per cent and 27.7 per cent, respectively. SMFG, however, managed to marginallyboost full year net profits, by 4.6 per cent; whilst the Resona Group, despite steering clear ofsub-prime problems, still suffered a 55 per cent fall in net profits. For Mizuho, the bulk ofwhose sub-prime trades were booked through its brokerage office in London, thesub-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 bythe banking sector, the three mega banking groups having already fully repaid during fiscal2006.

JFRC17,1

26

9. The transition to a Basel II basis of assessment for internationally active banks had littleimpact on reported ratios, although it did reduce risk-weighted assets for some (Bank ofJapan, 2007). Most of the major banks adopted the foundation IRB approach, duly reportingoverall risk-adjusted ratios of 12 per cent plus at end-March 2007, with Tier 1 ratios in excessof 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 howseriously 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 ofoperating income in fiscal 2006, with income from trading (e.g. forex and derivatives) andother sources amounting to 5 and 27 per cent of total operating income, respectively. Thismeant 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 fellfrom 57 to 49 per cent.

As far as lending activities are concerned, in the face of weak demand from theirtraditional customers – large corporates – the banks have diversified into M&A and realestate 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, withMUFG and SMFG seeking increased exposure through strategic investments in MerrillLynch (MUFG has a $1.2 billion stake) and Vietnam’s Export-Import Commercial Joint StockBank (SMFG has a 15 per cent stake), respectively.

12. “Alternative investments” accounted for nearly 10 per cent of the total balance of “securitiesand monetary claims bought” for the major banks at end-September 2007, with the regional’sshare standing at 7 per cent.

13. Through, for example, using more sophisticated credit-scoring techniques and portfoliocredit risk models, making use of credit bureaus and adopting an integrated riskmanagement approach.

14. Although a rise in market interest rates – policy rates are still at 0.5 per cent – wouldproduce an adverse impact on bank profitability in the short run, because of the induceddecline in the market value of bond portfolios, in the medium term it is likely to improvebank 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 theworld’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, iscurrently being held up because of a hung Parliament, with little legislative action nowenvisaged until January 2008 at the earliest.

17. See Fukao (2007) (Table VI) for an estimate of “under-reserving” during the fiscal 1997 tofiscal 2005 period (e.g. at end-March 2006, estimated under-reserving amounted to ¥8.3trillion 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.


27

FSA (2008), The Status of Non-performing Loans as of End-September 2007, Financial ServicesAgency, 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 thesituation 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 deEconomica 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 ROEanalysis”, Bank of Japan Review Paper, 2007-E-3, Bank of Japan, Tokyo.

IMF (2003), “Japan: financial system stability assessment and supplementary information”, IMFCountry Report No. 03/287, IMF, Washington, DC.

Japan Center for Economic Research (2003), “Profitability of corporate, banking and lifeinsurance sectors (in Japanese)”, Financial Research Report No. 8, Japan Center forEconomic 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.


Further reading



Corresponding authorMaximilian J.B. Hall can be contacted at: [email protected]


JFRC17,1

28

Multinational banking in Chinaafter WTO accession: a survey

Chen MengCentre for International Business, University of Leeds, Leeds, UK and

University of International Business and Economics,Beijing, People’s Republic of China

Abstract

Purpose – The purpose of this paper is to understand the market entry dynamics of foreign banks inChina.

Design/methodology/approach – The paper employs multi-method approaches combining bothquestionnaires survey data and qualitative interviews. Also, integration of internalization theory (atthe macro level) and strategy literature (at firm level).

Findings – The paper clarifies why and how foreign banks enter the Chinese market, and strategiesadopted to cope with local market dynamics; also, the paper identifies major trends and keycompetitive advantages of foreign banks.

Practical implications – Major advantages and weaknesses have been identified, which will helpforeign entrants to make greater inroads into the domestic banking market. The paper shows how tomanage risks and make governance structure more efficient and transparent, which are urgent tasksfor policy makers.

Originality/value – The paper utilizes the first nation-based dataset to investigate the Chinesemarket, and offers practical implications for local regulators and policy makers and bankers.

Keywords Multinational companies, Banks, China, Market entry, Emerging markets


IntroductionBanking services share most of services nature of being intangible, non-storableand untransportable, and cannot be traded without requiring the providers orreceivers to physically relocate. Multinational banks do not implicitly differ from themanufacturing firms, therefore theories derived from manufacturing MNEs are likelyto be applied to explain banking internationalization. Existing research ofmultinational banking focuses on developed countries (Goldberg and Saunders,1980; Goldberg and Johnson, 1990; Fuentelsaz et al., 2002), little light has been shed ondeveloping countries. The market entry and development of foreign banks in China is aphenomenon that demands greater attention from both academics and practitioners asChina’s economic status further strengthens. It is believed that the banking sector inChina provides grounds for generalizing the identified results to other financial serviceinstitutes. Firstly, banking is an important sub-sector of the services industry andshares most of the service features in general. Secondly, the banking sector has beenused in prior studies to analyze trends in the financial service industry.The mainstream international business literature focuses on the analysis of thenature of the banking industry. Finally, the opening up of the regulatory environmentin China makes it attractive for financial institutions to invest. Hence, the findings wepropose on internationalization drivers, evolutionary entry strategies and competitive



Multinationalbanking in China

29


Vol. 17 No. 1, 2009pp. 29-40


DOI 10.1108/13581980910934027

advantages provide practitioners of financial service firms with relevant informationand recommendations about future strategies.

The rest of the paper is structured as follows. The next section discusses theadopted research methods. China’s banking regulations under the WTO rules and thecurrent local market segmentations are discussed in the third section. The paper thenexamines the major market entry trends and characteristics of foreign bankingactivities in China. This leads to implications for banks and policy makers. We endwith conclusions.

Research methodsDiffering from existing literature, this study adopted a multi-method researchapproach that combined both aggregate level data and firm level data. There exists agap between static model of multinational banking and dynamic elements of bankingstrategy. Purely aggregate data are not sufficient in studying bankinginternationalization. The growth of the bank is largely determined by the internalresources of the bank such as reputation, experience, innovations, managerial abilityand technological know-how. How banks cope with external knowledge, manageknowledge transfer and apply new knowledge to commercial end is the key to bankinginnovation and adaptation (Amit and Schoemaker, 1993; Anderson and Kheam, 1998;Foss and Eriksen, 1995). At business strategy level, this relies on the management’sperceptions of the bank’s competitive advantages.

Firm level data were collected via self-administered surveys and semi-structuredinterviews. 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 orientationsand 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 tothe senior managers of all the 178 foreign banks in mainland China based on theparticulars 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 responsesexhibited a good representation of foreign banks in China. Representation of thesample was assured via the calculation of the proportion of banking activities andcurrent 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 thequalitative data to support the internal and external factors that drive banks’ entrystrategy. Such a multi-methods research strategy followed Miles and Huberman’s(1994) research guidelines. Questionnaire and interview data allow us fortriangulations. We can be confident of the robust and reliable nature of our results.

Regulations and market segmentationsChina’s WTO accession presents a great opportunity for foreign banks to expand.About 178 foreign banks were authorized to establish 163 branches, 223 representativeoffices, eight wholly owned subsidiaries and five joint ventures in China by the end of2005. The number of branches and subsidiaries of foreign banks increased to 254 by theend of 2006. The total assets of foreign banks in China experienced a steady growth over

JFRC17,1

30

the last two decades and reached US$171.463 billion at the end of 2007. A total of 154foreign banks have received license to conduct RMB business across 25 Chinese cities.A total of 25 foreign financial institutions have acquired minority equity control of20 domestic Chinese banks (China Financial Stability Report, 2006) by the end of 2005.Full market liberalization since 2007 certainly brings far-reaching implications to foreignbanks. A number of banks such as HSBC, Standard Chartered, Citibank and Bank ofEast 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, typeand currency of products and services, operational volume, customer base, number ofbranches and location of foreign bank operations. The main barriers are likely to be theminimum two-year operation in China (three years for conducting RMB business) priorto formation and the one-year mandatory waiting period for establishing additionalbranches. What is inconsistent with international practice is that the introduction ofnew products within a foreign bank’s authorized scope of business requires the PBOC’sprior approval. The latest regulation released by the end of 2006 states that foreignbanks must receive independent Chinese legal person status in order to conduct RMBbusiness to Chinese individual customers. This requires foreign entrants to inject moreregistration capital. There are many other invisible ways for the government to affectthe pace of foreign banks’ penetration such as encouraging large state ownedenterprises to use domestic banks, setting obstacles to the use of domestic networks byforeign banks, and complicating and prolonging the procedures for approving specificbusiness of specific foreign banks.

China’s “big four” state owned commercial banks still dominate the local bankingmarket. They accounted for over 51.3 per cent of the local banking assets, loansand deposits at the end of 2006. In contrast foreign banks only accounted for about2.4 per cent of China’s banking assets (PBOC Quarterly Statistical Bulletin, 2002-2008).Foreign banks are unevenly distributed by region. Foreign bank branching activitiescluster in special economic zones (SEZs), open cities in coastal area and several authorizedcities. Beijing and Shanghai are two most preferred locations given their politicalimportance, healthy business environment and efficient government services.Foreign banks also target the inner regions as the second step long-term businessexpansion 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 cottonpeasants from Xinjiang Autonomous Region. HSBC opened its presence in rural areas ofHubei province and Chongqing municipality city to provide loans for peasants andtownship enterprises. Foreign banks have a competitive edge in both retail and corporatebanking in the areas of financial soundness, risk management and financial innovationwhich constitute the key ownership advantages. However, the Chinese banks arecatching up quickly in recent years, particularly in traditional banking market (mainlyinterest-based business). This intensifies local market competition.

Market entry trend and characteristicsMotivesForeign banks exhibit a mix of motives including both market seeking and followingthe client and other motives of which driven by competition, being the first mover,


31

geographical diversification and cultural connection are the most important. Banksoften simultaneously combine several strategic motives and the dominance of thesemotives may switch over time with the accumulation of local client base and marketknowledge. Entry motives vary across different business segments. Market-seekingmotive is still the dominant strategic orientation in market entry decisions across thewhole banking business segments. Investment banks and retail banks are purelydriven by seeking local market development. For corporate banks, following the clientsis still important. Many foreign banks consider following the clients as a emergentstrategy during the initial entry. The amount and quality of source country FDIstrongly influences a bank’s decision to open branch. For trade-related bankingbusiness, there can be both aggressive and conservative motives behind.

Mode of controlOrganic growth remains the most attractive option of foreign banks to increase theirmarket presence in China. As some bank managers commented, “wholly owned modeis more preferable if the parent bank wants to transfer its know-how to the overseasoffices safely and at a lower cost.” Establishing multiple branches is critical for servingcorporate clients and for local retail banking. The best practice to explore local marketand establish brand awareness is via branch banking which is still the cornerstone ofbanking strategy.

Equity acquisition in local commercial banks is the second-best option. For universalbanks, 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 allowsforeign 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 issuingco-branded credit cards. The local governments normally hand pick foreign banks forstrategic alliance based on their financial strength, reputation, track record, technologyplatform 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 theend of 2007, CBRC has approved 21 foreign banks to reorganize their Chinese branchesas 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 haveestablished local entities with most headquartered in Shanghai. A few more likeJPMorgan have applied for the same. Not all banks deciding to register as a local entityare aiming at retail business. The impact of local incorporation would havefar-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 toprofit from local growth because full decision power will not be obtained with only20 per cent ownership. It is difficult to cooperate with a Chinese bank without fullcontrol through equity because there is a risk of losing bargaining power and dilutingcompetitive advantages after the transfer of IT systems and other critical capabilities.

Outsourcing is also evident in local banking strategy. Foreign entrants capitalize ontheir specialized core business areas while outsource functions that do not add muchvalue to their overall development strategy. By doing so, foreign banks can improveoperational efficiency and reduce risks. Domestic Chinese banks can facilitate foreign

JFRC17,1

32

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

Strategic choicesBased on our empirical findings, we develop an evolutionary framework ofdevelopment strategies of foreign banks in China (Figure 1). The frameworkexhibits three main strategic options: client leadership, product leadership andmulti-objective strategy. Client- and product-leadership strategies are interrelated.The difference lies in the allocation of core banking resources and strategic objectivesthat banks pursue. Banks may perceive external environment differently and maypossess different bundles of internal resources, hence they may choose to adopt onestrategic option over the other.

In pursuit of client-leadership, foreign banks focus on maintaining their key existingclients by introducing sophisticated client portfolio management. Client basediversifies with the development of the local market. In order to avoid directcompetition with domestic banks, foreign banks tend to target niche market orneglected client segments such as rural market and small to medium sized local privateenterprises. Although diversification of client base takes place gradually, a trend canbe observed that local corporate clients are taking over FIEs in terms of revenuecontributions. For specialized retailing banks, they are seeking aggressive local marketexpansion by establishing locally incorporated subsidiaries and nation-wide retailingoutlets.

Figure 1.Strategic choices of

foreign banks in China

?

Low

High

Low High

Product leadership/Marketing and distribution

Client leadership/Marketing and distribution

N C

P U

Market exit

= A necessary moveby will or forced bycompetition

Competitiveness

Com

petitiveness


33

In pursuit of product-leadership, product innovation and a restructure inproduct portfolio appear to be the only sensible solution. Traditional interest-basedbanking products lack of differentiation. Any new change can be easily copied bydomestic banks in a short period of time. Static foreign exchange rate and interest ratealso squeeze the profit margin in traditional commercial banking business. Foreignbanks need to shift product focus from traditionally interest-based services tohigh-order fee-based banking products. Product innovation does not merely refer tointroduction of new products. It can also mean a modification of existing maturedproducts, innovative solutions in sales and marketing, and improvement in efficiency.In practice, it means that banks may need to market their products in an innovativeway. Adjustments involve not only product concept but also technological platform atthe 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 facilitateefficient internal coordination are critical. Universal banks (U), particularly thosespecializing in retailing business, tend to achieve synergistic leaderships in bothclient and product by establishing multiple branches and concentrating on productinnovation. A good organizational learning culture contributes to more efficientexploitation of external knowledge, client management, product innovation andcreative marketing.

In contrast, banks that are unable to improve their competitiveness in neitherproducts 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 ofthe banks do not have the strength to achieve both economies of scale and economies ofscope. They may focus on one strategy at a specific time and move to the other strategyat another time. In this dynamic framework, banks may pursue different strategicfocuses over time and their paces of development vary greatly due to the heterogeneityof bank-specific attributes. There is no “one size fits all” strategic approach to themarket entry of foreign banks. Market expansion develops incrementally andstrategies need to be understood and implemented under the notion of dynamism andpragmatism.

Determining factors and competitive advantagesTable I exhibits the logistical regressions results for scale.

Market development is dependent upon the firm-specific advantages that a bankpossesses. In order to increase the local market commitment/penetration in China,foreign banks need to be competitive in following firm-specific attributes: productinnovation, ability to develop key clients, ability to adapt technology to the localstandard, ability to attract and recruit local expertise, ability to meet the latent demandof the Chinese banking market and cultural proximity. Meanwhile, foreign banks needto have a persistent long-term strategy in China. Many of these attributes are central tothe adaptation process in China. For instance, foreign banks with excellent learningculture usually can more efficiently deliver innovative financial products that arecompatible with local market regulations and demand. Banks from Hong Kong andSouth East Asia appear to be advantageous because of their cultural and languageproximity. They demonstrate a faster pace of local market penetration.

JFRC17,1

34

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scale


35

How can banks adapt into the local market by minimizing their risk exposure withoutlosing opportunities for growth? The answer to the question very much relies on howbanks cope with external knowledge and maximally exploit their competitiveadvantages accordingly in the foreign market. Both qualitative and quantitativeanalyses show that bank size and client resources are obvious factors that affectthe growth of foreign banks in China. Bigger banks not only enjoy the advantage ofdiversity but also have much more scope to sell off assets in times of trouble. In theorythey should be better in credit analysis too because they have more data to combthrough and more opportunity to spread the cost of investment in things like ITsystem. The benefits of scale and diversification are much more apparent when thegoing is tough. Universal banks can diversify risk more easily than smaller-sizedspecialized banks and find themselves open to more options in terms of entry routechoices. Banks tend to develop faster by relying on and extending their existing clientnetworks in China. For market-seeking banks, the capability to cultivate a sound localbusiness environment and develop local clients lies in the centre of sustainablelong-term growth. Differentiation of banking services very much depends oninnovation in client management and product services. Individualized services,price-competitive products and delicate care of client relationships determine whethera bank can retain old clients, continuously engage in new client relations and delivernew products to the end-users more efficiently and effectively than its competitors.Banking services are highly leveraged. A small difference even an improvement inefficiency would lead to differentiation, which in turn can cause barrier of entry forother market players.

We further identify that organizational learning and internal coordination, qualityof managerial resources and cultural proximity are vital in dictating anddifferentiating the development pattern of foreign banks. Each factor turns out tofeature different development stages and their roles in affecting the degree and timingof local market expansion vary. How banks cope with external knowledge and beinginnovative in creating new knowledge for sustainable growth is an essential element inshaping developing strategies. High quality managerial resources facilitate knowledgetransfer and the creation of new knowledge. The effectiveness in knowledge absorptionand generation is the key to banking innovation and adaptation. Better training and apool of qualified managerial staff also ensure a good communication internally andwith clients or regulators. Ultimately this can enhance performance and speed up thepace of expansion. Cultural closeness is an uncopiable advantage that offers banksquicker access to the local market. An in-depth understanding based on similarcultural background and a common language facilitates business innovation andadaptation in the post-entry development.

ImplicationsIn total, 80 per cent of our surveyed banks indicate that profit has been growing above40 per cent in the last two years. The optimism of foreign banks is evident. Thebusiness of foreign banks operating in China is booming and will continue to expandwith a growing Chinese middle class, soaring foreign investment and the opening up ofthe regulatory environment. But surely there are lessons to learn from the pastexperience.

JFRC17,1

36

Implications for foreign banksForeign banks that capitalize on specific opportunities and market growth in Chinaneed 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 inconstructing banking strategy. Such knowledge can only be acquired and developedthrough an incremental learning-by-doing process. There is no alternative route to skipthis learning stage. Foreign banks who want to catch up in the race of local marketexpansion will have to make a concerted effort over the medium to long-term to buildtheir infrastructure base including networks, client resources and human assets.

Any attempt to confront a face-to-face competition with Chinese banks would comewith extremely high cost and sometimes would lead to the failure of the whole businessplan. In order to succeed in China in the long run, foreign banks will need Chinesebanks to be successful in their restructuring programmes so that the market as awhole develops and matures. Therefore, improving the competitiveness of the Chinesebanking industry as a whole will bring a win-win outcome that both Chinese andforeign banks can have a share of a bigger market.

The recent US sub-prime crisis raises particular skepticism about whether largewestern banks or their regulators truly understand the risks associated with derivativeon their balance sheets. Attitudes towards foreign financial institutions are hardeningpublicly in China. Liu Mingkang, Chairman of the CBRC, indicates that China is likelyto open up to international banks even more slowly than it has already. The market hasringed bells for foreign banks to implement more careful and smarter risk managementstrategy. The fact has shown how hard it is to quantify risk in a less transparentmarket. Credit analysis remains critical to the functioning of the financial system.No other institutions have the infrastructure, the people, the data and the reputationsthat the banks can call on to carry out that task. However, “know your customer” isstaple of banking that has largely been forgotten because of the disaggregation of thesupply chain. There is now likely to be more emphasis on non-statistical ways ofthinking about risk. That means being more rigorous about imagining what could gowrong and thinking through the effects.

Intensified local competition has pointed to the value of having stickier retaildeposits, especially now that wholesale funding costs have rocketed. Even if foreignbanks are successful in bringing new money in, two deeper questions remain. The firstis whether the new money will stay. Banks need to deliberately target lessrate-sensitive customers or offer high-yielding products. The second question is howmuch money banks can make if they have to compete so hard to entice savers. Thereare ways to offset the higher costs of deposits, for example the structured accountswhere the payouts are linked to the performance of equity indices and where risks canbe hedged, but such products are definitely not for mass market and limited by localmarket regulations.

Implications for Chinese banksFrom the perspective of Chinese banks, they had a five year “grace period” to gear upto 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 andmaintain their existing market shares.


37

Public listing is only one of the means to mitigate the pressure caused by previouswrong lending decisions and push local banks toward real commercialization. Moreeffort needs to be made internally. This includes the improvement of corporategovernance, credit and risk management, product innovation, marketing, security andhuman resources management. A greater emphasis on capital and liquidity will haveconsequences for the business models of many local banks. Adjustment in riskmanagement strategy also means more selective lending in order to keep asset growthunder control. There is plenty of scope to improve performance with operationalchanges. This signals more rights issues and in some cases it also means M&Asactivity. Banks with lots of capital are in a stronger position to deploy it but will bevery careful with their due diligence.

Medium and smaller-sized Chinese banks should take a more domestic approach tofocus on their existing markets. Their advantages are that they are less burdened thanstate-owned banks and more flexible and efficient in adopting new technologies andmarketing skills. It enables them to identify neglected market niches and make quickresponses. Sometimes teaming up with multinational players can offer them a big leapforward. However, potential partners need to be carefully chosen. For equity alliance,Chinese banks need to pay extra attention to the establishment of common interestsand reduction of threat of becoming potential competitors. They also need to build upcompatible management practices and maximally explore complementaritiespossessed by both partners while not risk losing bargaining power and dilutingcompetitive advantages.

In terms of risk control, Chinese banks need to learn credit analysis techniques fromwestern banks. Western banks normally issue non-collateral lending based on theircredit 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 stillthey encounter huge NPLs. Western banks adopt a mature system for portfoliomanagement so that they can reduce or hedge risks effectively. How to best allocatebanking assets and keep a minimum risk is the core to Chinese banking reforms. Forstate-owned banks, the challenge is how to pass on good experience and best practicesthroughout their hulking organizations.

Implications for policy makersBanking industry always has the highest government intervention. The liberalizationpace of the Chinese banking and financial market is much faster than that of Japan andthe USA. Drawn from experiences, regulators need to pay extra attention to thefollowing areas. The first is to take a broader view of risk. That means looking atoff-balance-sheet assets and at gross exposures. The entry of foreign banks certainlybrings new challenges to the Chinese regulators. One of the challenges lies in thetreatment of innovative products. New products such as securitization widen access tocapital for borrowers and to assets for investors. Leverage brings more lazy companieswithin reach of determined investors. New products do not just lack the historic data thatfeed 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 bothlosses and gains, creating huge uncertainty. That makes it impossible to get anaccurate picture of aggregate risk even if individual risks are being managed well.

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As one regulator from the central bank notes, “we have all the sheep in the sheepfold butnot the sheepfold”. Risk management will concentrate much more on the size of banks’absolute exposures. The quality of risk management at individual institutions does notnecessarily provide enough information about the overall stability of the system. Manybelieve 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 furthercomplicate the regulatory framework.

Second, regulators need to push banks to build buffers when times are good so theyhave stronger defenses when times are bad. This requires banks to increase theamount of capital and liquidity that banks set aside when risks are building, andreducing the amount of leverage they can take on. Risk is rarely understood until afterthe fact. Banks may actually run higher risks in order to compensate for the effects oftougher capital requirements.

Third, world economic downturn and rise of inflation are issues that Chineseregulators and decision makers urgently need to tackle with in order to increase vitalityof domestic financial market and maintain the stability of macro economy. China’s trueinflation rate may be higher because the consumer-price index does not properly coverprivate services. China may need to allow more flexibility in their exchange rates.The revaluation may also encourage investors to expect further appreciation, whichmay attract more inflows of speculative money and so exacerbate inflation.A state-driven financial market means state firms tend to do best. Financing forstart-ups remains largely informal, which stifles entrepreneurship. Chinese citizens tryto 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 depositsyielding less than inflation or speculating on highly volatile shares. Stimulatingdomestic demand is correct on the one hand, reforming financial markets is inevitable.

Fourth, entry of foreign banks urges reforms in China’s governing and legalsystems. Frictions increase while foreign banks deepen their local market penetrationin the last several years. Banks operating in different jurisdictions need time to adapttheir banking practices into the new market. Problems also arise from China’s complexgoverning structure. Cross-selling strategy currently adopted by foreign banksobviously introduces new challenges to the governance of financial services.There have not been any rules or regulations specifically relating to such complicatedfinancial service packages. In addition, it is very often the case that rules erected bydifferent governing bodies clash with one another or at least not consistent.The complication in governing structure reduces the transparency and efficiency ingovernance. It further leaves many unexplained “gray areas” for financial practicesthat both regulators and business practitioners find difficult to cope with.

ConclusionsThe Chinese banking system clearly needs reform in terms of the introduction ofinnovative foreign practices. However, policy makers also need to bear in mind the stabilityof 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 andcharacteristics of foreign banking in Mainland. The paper offers important insightand implications to the understanding of multinational banking in emerging markets.


39

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 growthstrategies: 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 inLondon 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 Spanishbanking 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 ofGreat 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 andpropositions”, Journal of International Business Studies, Vol. 17 No. 3, pp. 1-26.

Corresponding authorChen Meng can be contacted at: [email protected]

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An overview and assessmentof the reform of the non-tradableshares of Chinese state-ownedenterprise A-share issuers

Paul B. McGuinnessDepartment 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 sharereforms relevant to Chinese A-share issuers listed in the two mainland markets of Shanghai andShenzhen. The reform programme first began in 2005 and has now spread widely across issuers in thetwo markets. It is therefore timely to assess how effective the reforms have been as well as gauging theongoing 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 amajor policy initiative in China and potentially opens-the-door to large-scale state-share disposals. Theevidence to date however suggests that the Chinese authorities are primarily concerned with thereconfiguration of the array of share types that presently exist into a more comprehendible, streamlinedform. The various checks and balances imposed on controlling shareholders engaged in thetransformation of their shares from non-tradable to tradable form suggest that eventual re-designationof the holdings into an unfettered tradable type will not necessarily translate to the state’s acquiescencein the disposal of such shares. On the contrary, state holdings in the most strategic of assets are likely tobe retained more or less intact. Insights are developed by focusing on examples involving major A-shareissuers. In particular, a case study of the Sinopec reform proposal of August/September 2006 is set out tohelp illuminate the principal features of the reform package. Critical examination of the empiricalliterature 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 andmost strategic of China’s issuers. However, for a number of A-listed issuers, parts of the lock-upmoratoria have already expired or are set to do so in the very near future. Given the precipitous fall inA-share prices (in Shanghai and Shenzhen) since late 2007, largely wrought by the enveloping globalcredit-crunch, the Chinese authorities have an even more compelling case than hitherto to assiduouslydampen fears of large-scale state-share disposals. Notwithstanding this, at least a small part of thedrop 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 stillapplies in most cases, at least in respect of the majority of domestic stock holdings, a clearer picturewill 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 issuewithin 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 ofThe Journal of Financial Regulation and Compliance, Dr Charlie Cai, for his valuable commentson an earlier draft of this paper.

Reform of thenon-tradable

shares

41


Vol. 17 No. 1, 2009pp. 41-56


DOI 10.1108/13581980910934036

1. BackgroundThis 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 allissuers on its two constituent mainland markets: Shanghai and Shenzhen. The reformspecifically serves to re-designate non-tradable stock, in mainland PRC-incorporatedissuers 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 thatmost 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 stockwill mark the complete metamorphosis of the originally non-tradable stock into atradable form completely unfettered by trading restriction. While brief comment on thetransformation 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 tradingmoratoria imposed on such re-configured “restricted” shares have in many cases justlapsed or are about to do so.

As argued at the outset, this transformation is a creeping or gradual one, buteventually will entail a huge increase in the supply of tradable A-stock, as the newlyconverted stock complements pre-existing tradable A-share floats. The burningquestion is what impact will such an increase in tradable float size have on A-sharevaluations? To some extent, Chinese A-prices have already impounded the anticipatedeffect. However, as shall be argued later in this paper, a building risk premium ordampening 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 regulatorypowers and controlling shareholders have tried to lessen the building risk premium arecentral considerations in the whole share reform programme, and are critically assessedin the second-half of this paper.

Before focusing the spotlight on this issue, a brief discussion of the nature of the “SplitShare 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 thensets out the key characteristics of the share reform programme. Specifically, the nature ofthe proposals, and the associated compensation and voting privileges extended to existingtradable A-share investors are scrutinized and illuminated within the context of a detailedcase study. In Section 4, attention focuses on a minority of SOEs that are able to issuetradable shares not just in A-share form but also in B- (or H-) share form. While in the vastmajority of cases mainland PRC-incorporated issuers only have recourse to tradableA-shares, a select group of very large and strategic issuers have been meted-out forconcurrent 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 disclosedprovisions on the permissible methods of share disposal, and the associated disclosurerequirements, for stock transformed from domestic, non-tradable form into tradableA-share form then features in Section 5. Conclusions logically follow in Section 6.

2. The “Split Share Structure” of A-listed mainland PRC-incorporatedSOEs: the non-tradable/tradable stock dichotomyDomestic Chinese mainland shareholders afforded the privilege of share conversionunder the CSRC’s (2005) “Split Share Structure” reform typically constitute state-related

JFRC17,1

42

concerns, and hail from the regulatory, governmental or corporate-spheres. Such stateparties are sometimes joined by domestic “legal-person” shareowners and, occasionally,employee-based stock owners. In the vast majority of cases, state-related partiesdominate within the domestic non-tradable stock component. Moreover, domestic,non-tradable stock accounts for more than 65 per cent of stock outstanding across the1,500 or more listed A-share issuers (on the Shanghai and Shenzhen exchanges).Reference to the “China Stock Markets Web” facility at Hong Kong Exchanges andClearing Limited (www.hkex.com.hk/) reveals that as of 24 October 2008, the tradableA-share market capitalization of Shanghai and Shenzhen combined was RMB3,994 billions, as compared to a total market capitalization figure for the two markets ofRMB 11,874 billions. The latter is computed by imputing value to domestic, non-tradablestock 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 withmarket price RMB 5 and 7,000 million domestic, non-tradable shares. The marketcapitalization 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 thenegotiable component plus the value imputed to non-negotiable component, of RMB50,000 million. Leaving aside the issue of whether such an imputation exercise makesgood economic sense or not, one can see that across the whole market the ratio ofnon-tradable stock to tradable A-stock is of the order 2 to 1 (or, more precisely, 66.36 to33.64 per cent). It is also important to emphasize that in a given entity like ABC thetradable 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 parvalues, typically at a level of RMB 1.00) and capitalization benefits. The only differenceis the trading right. The unravelling share reforms will of course eventually removethis 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 totrading restriction”. Such reconfigured shares, as representations of hitherto purelynon-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 ofthe 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 forthe 1,500 or more listings across the Shanghai and Shenzhen market places. Duallistings of such shares are not apparent, so that issuers on the Shanghai market areseparate from those in the Shenzhen market. The Shanghai market accommodates thelargest of issuers in terms of market capitalization and, by and large, Shenzhen catersto small-to-medium sized concerns, especially those with a focus on the Pearl RiverDelta. Owing to a restriction on trading rights, tradable A- stock is only accessible byparties/entities indigenous to the Chinese mainland and thus constitutes domestictradable scrip, as opposed to foreign tradable stock (B- and H-shares, to be discussedlater in this paper[1]). The only foreign party afforded access to China’s tradableA-share market is the Qualified Foreign Institutional Investor (QFII). QFIIs constituteinvestment entities from Hong Kong, the rest of Asia, North America and Europe, andas shown in Ferguson and McGuinness (2004), have limited investment scope due toconstraints imposed in relation to the choice of A-share investment, the investmentholding period (or lock-up arrangements) and the earmarked quota for investment.


shares

43

To all intents and purposes, then, the tradable A-share market is a market for mainlandChinese (i.e. domestic) investor concerns. Its segmentation from overseas markets canbe 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 withinthe context of mainland China’s equity markets/capital control policies), unless affordedthe QFII trading-mantle, can only trade in the B- and H-shares of mainland-incorporatedSOEs. B-shares, as traded in US$ in Shanghai and in Hong Kong Dollars in Shenzhen, aresomething of a side-show these days, given the small number of listings, float size and themoribund 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 onequoted outside mainland China, where virtually all trades take place betweennon-mainland parties. However, Qualified Domestic Institutional Investors andmainland retail investors, in compliance with the provisions of the 2003 CloserEconomic Partnership Agreement between Hong Kong and Beijing (Su et al., 2007), haveenjoyed limited access in recent years. In addition, a number of mainland Chinese entitieswith 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 ofUS-listed American Depositary Share programmes (Arquette et al., 2008) are issued onmajor Hong Kong-listed H-counters. Such ADSs are often referred to as “N-shares” andconstitute an additional listing of the underlying H-shares, albeit in ADS form.

Finally, in assessing the nature of the reform programme, it should be madeabundantly clear that while eventual listing of the “G-shares” offers the potential forstock disposal by domestic parties (principally state-related share owners), some levelof political ascent would inevitably be required before controlling parties were affordedsuch a privilege. In many ways, then, the overarching objective of the reformprogramme is one of simplifying the share structure of China’s mainland-incorporatedSOEs, 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 “SplitShare Structure” (CSRC, 2005) of an A-listed mainland-incorporated issuer into a unifiedtradable (A-share) form. Removal of the “Split Share Structure” would ultimately pushsuch mainland-incorporated issuers a little closer in the direction of theoffshore-incorporated “Red-Chip” counter. The latter, as exemplified by HongKong-incorporated issuers China Mobile, CNOOC and China Unicom, in which majorstate-related shareholders are present, are issuers with 100 per cent of their outstandingstock in tradable form. Even after completion of the “Split Share Structure” reform,mainland-incorporated issuers would still be different to “Red-Chips” in two importantrespects. 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) ratherthan the single ordinary share type apparent in the “Red-Chip” issuer.

3. Essential features of the share reform programmeThe re-designation (of domestic non-tradable stock) into tradable form first began inMay 2005 when the China Securities Regulatory Commission (CSRC) announceda Pilot Scheme targeted at four A-share issuers (O’Neill, 2005a). The scheme was dulyenlarged to 46 issuers one month later (Tang, 2005), and then extended across more orless the whole A-share market during the second half of 2005-2007. The progressionacross the market has been such that virtually all established issuers on the Shanghai

JFRC17,1

44

and Shenzhen A-share markets have now garnered support for the requisite sharereform proposals. The details of the various provisions governing such schemes are asstipulated by the CSRC (CSRC, 2005) and discussed in the following.

3.1 Case study of The China Chemical & Petroleum Corporation (Sinopec) share reformproposal of August/September 2006To bring the share reform proposal discussion into focus, study of the reconfigurationof China Chemical & Petroleum Corporation’s (Sinopec’s) non-tradable stockcomponent is set out in the following. Sinopec is chosen because it represents one ofChina’s largest and most strategic of issuers. It has also had share listings in place forsome time, with respective H- and A-listings established in 2000 (in Hong Kong) and2001 (in Shanghai).

The August 2006 share reform proposal, as mounted by Sinopec’s domesticstockholders, ultimately required support from tradable A-share investors for it to goforward. To compensate for the possible deleterious effect of such conversions on themarket price of pre-existing tradable A-shares – occasioned by the eventualtransformation of such stock into unrestricted tradable form – bonus shares wereoffered to existing tradable A-share investors on the basis of 2.8 consideration sharesfor every ten already held. The consideration shares in this context were shares offeredfrom existing domestic, non-tradable holdings with arrangement made for theirimmediate conversion into tradable A-share form upon completion and acceptance ofthe share reform proposal.

3.1.1 Provisions governing the form of the Sinopec reform proposal. As set out inArticle 5 of the CSRC’s pronouncement on the subject, a proposal can only get off theground 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 beforethey propose a motion on the split share structure reform. In case of a consensus cannot beaccomplished, such motion may be proposed by a shareholder/shareholders holdingindividually/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-thirdmajority amongst the voting tradable A-share investors. Article 16 sets out theprovisions on this matter:

The reform plan of a listed company shall be approved by shareholders with at leasttwo-thirds of voting shares at the relevant shareholders’ meeting. Such reform plan shall alsobe approved by the tradable shareholders owning at least two-thirds of tradable votingshares at the relevant shareholders’ meeting [CSRC (2005, Article 16)].

Lee (2008, pp. 70-2) offers a critical assessment of the various voting provisionsand notes, amongst other things, that tradable A-share investors may not necessarilybe 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 andnon-tradable – in relation to Articles 5 and 16 in the CSRC (2005) stipulations – lentstrong support to the reform proposal (Sinopec, 2006e).

Essentially, Sinopec’s reform proposal saw an almost immediate transformationof its pre-existing share structure (see Table I, part (a) and the reconfigured one in


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45

Table I, part (b)). Acceptance of the proposal had no effect on the total number ofshares outstanding, nor on the number of H-shares outstanding. However, the tradableA-share pool was enlarged by 28 per cent, in accordance with the 2.8 for ten bonusissue. The number of tradable A-shares thus rose from 2.800 billion to 3.584 billionshares, with the 0.784 billion share increase obtained through the transfer andconversion 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 singlelegal-person share owner, “Guotai Junan Securities” (Sinopec, 2006f, p. 3). The relativeconsideration paid by each of the two domestic shareowners in Sinopec wasdetermined in proportion to their pre-proposal holdings.

As noted in Fang et al. (2008, pp. 25-6), share reform proposals typically result intwo-periods of trading suspension for the underlying issuer. As reflected in data extractedfrom Datastream, Sinopec’s tradable A-shares (code 600028) were suspended from tradingon the Shanghai Stock Exchange for a period running from Monday, 21 August 2008 toWednesday, 6 September 2006 (13 trading days) and between Friday, 15 September and9 October 2006 (17 trading days). The first suspension was triggered following the initialreform announcement (Sinopec, 2006a) and came to a close shortly after the confirmationof the terms of the reform proposal (Sinopec, 2006c). With regard to the latter:

After publication of the share reform scheme [. . .] directors assisted the communicationbetween the holders of non-tradable shares and investors through visits, holding of investors’seminars, conducting internet road-shows and establishing hotlines, etc. Based on theseresults [. . .] the share reform scheme of the Company shall remain unchanged (ChinaPetroleum & Chemical Corporation (Sinopec), 2006, p. 1. Capitals shown as used).

The second suspension was ushered-in by a notice (Sinopec, 2006d) informingshareholders 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 SharesDomestic shares 66,535,191,000 76.74State-owned legal person shares 586,760,000 0.68Listed and circulating sharesA Shares 2,800,000,000 3.23H Shares 16,780,488,000 19.35Aggregate number of shares 86,702,439,000 100.00(b) Share structure of Sinopec immediately following reform proposal approvala

Circulating A shares with lock-upDomestic shares 65,758,044,000 75.84State-owned legal person shares 579,907,000 0.67Circulating shares without lock-upA shares 3,584,000,000 4.13H shares 16,780,488,000 19.35Aggregate number of shares 86,702,439,000 100.00

Note: aFigures and categories extracted verbatim (in quotation marks), from “Share ReformAnnouncement”Source: Sinopec (2006b)Table I.

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indicated that upon completion of the record period for parties eligible for bonusshares, trading of the pre-existing A-shares and newly converted consideration shareswould commence 10 October 2006.

One of the most important features of the reform programme concerns the applicationof 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-outacross a 36-month period following reform implementation, with absolute “lock-up” ofthe 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 theholder of the reform shares is able to list (and potentially sell-down) a proportion of theirshares 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’, afterwhich time CRSC “lock-up” provisions on the reform stock cease, and all remainingG-stock is therefore potentially eligible for listing and/or sale. However, a further layer ofapproval by the State-owned Assets Supervision Administration Commission maymean that more stringent “lock-up” provisions apply (China Daily, 2007). In addition, anumber of domestic controlling shareholders have sought to impose lock-uparrangements on their shares that go well beyond the base requirements set by theCSRC. Yanzhou Coal Company Limited provides such an example. In its reform proposalof 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 of48 months from the date of the completion of the Share Reform Plan. In the event thatYankuang Group fails to fulfill this undertaking, all monies received from the disposal of anyof such shares shall be paid to [. . .] the Company. (Capitals reported as used, “Announcementon 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-monthspost-reform) can be discerned from announcements on the subject (specifically, seeSinopec, 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 wereeligible 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 constitutedexactly 5 per cent in number of Sinopec’s outstanding stock position. After a further 12months, another 433,512,200 shares would become eligible for listing and after 36-monthsall of the remaining non-listed holding takes on listing eligibility. Reference to Sinopec’sAnnual Report (2007) and Sinopec’s Interim Report (2008, pp. 5-6) make it clear that ChinaPetrochemical Corporation had not disposed of any its 65,758,044,000 shares between thedate of the reform’s implementation and late August 2008, the point at which the InterimReport 2008 was disclosed.

The effects of the reform set out in Table I also make it clear that H-share holdersare excluded from both the compensation and voting arrangements. There is howeverno dilution in the ownership interest of H-share investors, as the consideration sharespaid 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 adoptedfor issuers with concurrent A- and B-share listings, in the sense that B-share investors


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47

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 economicexpediency, it behoves us to enquire if the discriminatory move can be justified on legalgrounds [. . .] It is hard to justify it on the principle of fairness because making non-tradableshares 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-shareissuers, in cases where both A- and H-share listings are in place at the time of reformproposal.

3.2 Market levels of consideration payment made by domestic stockholders to existingtradable A-share investorsThe 2.8 for 10 bonus (consideration) arrangement in the Sinopec case appears to liewithin the “normal” range for such payments. Fang et al. (2008, p. 32), in relation to 234of the 300 stocks represented in the “Shanghai Shenzhen 3000 Index”, for share reformproposals instituted prior to 1 July 2006, show that the median “distributionproportion” 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 ofthe 234 issuers they examined had “distribution proportions” between 0 and 20 per centand 73 between 30 and 50 per cent. While the terms of such bonus/compensationschemes vary considerably across issuers, the norm is that such (bonus) shares have noimpact whatsoever on the issuers’ total number of shares outstanding; instead theconsideration shares represent a transfer, and immediate conversion into unfetteredtradable 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 theyinvestigate. The vast majority simply appear to offer bonus shares from existingcontrollers, 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 haddirected share reform proposals to constituent tradable A-share investors prior to the2007 year-end, report an average “consideration ratio” of around 30 per cent. They alsonote that the higher the level of state ownership prior to the reforms, the greater theconsideration payment to tradable A-share investors, which they interpret, based upontheir model of such payments, as testimony of the relative bargaining position of thetwo 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 withthe increased price distortion emanating from the subsequent conversion of suchholdings, requires a greater consideration payment to be made. A related finding intheir study is that the consideration payment behaves inversely with the proportion oftradable A-shares outstanding. Two other significant results emerge. First, Li et al.(2008, p. 28) report that consideration payments tend to increase the lower theprofitability of the underlying issuer and, second, that such payment ratios havegenerally fallen over time.

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3.3 The announcement effect of the “Split Share Structure” reform proposals on issuers’underlying A-share pricesWhat about the impact of the various compensation packages on tradable A-shareprices? Fei et al. (2008) shed some light on this issue by considering cumulativethree-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 isconsistent with tradable A-share investors anticipating the approximate magnitude ofthe compensation package offered. A study by Feng and Xu (2007), of the first46 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 theoverall reform programme in quelling market uncertainty during the incipient phase ofthe reform’s introduction (to the overall market).

As Fei et al. (2008, p. 11) exclude issuers from the very first stage of the Pilot Schemeand have disproportionately more firms in their study sample from the third batch ofentrants onwards, the obvious deduction to be drawn from comparison of resultsbetween this and Feng and Xu’s (2007) study, which focuses on the first two batches ofentrants, is that as confidence in the share reform programme firmed during late 2005and through much of 2006, the effects of individual reform proposals on constituentshare prices waned somewhat.

As an interesting aside, it would be useful to know how the reform announcementshave impacted upon share prices of issuers with adjoining B- (or H-) listings. Despitedifferential 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 andMcGuinness, 2008; Arquette et al., 2008), a priori one would expect some spillovergiven an adjustment on the associated A-share price. However, due to the tradingrestrictions on A- and B- (and A- and H-) shares, for given issuers with concurrentlistings 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 beingmixed 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 afunction of the timing of the reforms, the consideration terms announced in the sharereform 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 theirpotential impact upon A-share valuationsThe question of the determination of the period of issuer lock-up (or “lock-in”) is also aninteresting one. One might conjecture that, for controlling players locking-up shares fora 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 theunderlying company’s future earnings capacity. Consistent with the Leland and Pyle(1977) signalling model, larger and more extensive lock-ups should act to supporthigher share valuations in the issuer. Application of this argument is a little morecomplicated in the case of the share reform issue though, as the “lock-ins” may owe asmuch to political motives as commercially-driven ones, given the nature of state-relatedcontrolling 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 somethingabout the nature of the state-related shareowner as well as the “confidence” of thecontrolling party (in relation to future cash flow returns). Clearly, research into thedetermination of the precise lock-up stipulations declared and their impact uponA-share pricing would be helpful to the present debate. It would be especially useful toknow how A-share prices respond in the immediate run-up to, and conclusion, oflock-up expiry.

In answering the final question, contributions from the IPO literature may bepotentially 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 thetime of lock-up expiry. They also cite (p. 1236 of their paper) evidence of negative priceadjustments at such lock-up expiry points in relation to US-listed firms. Their findingsfor the UK are perhaps of greater import to the present study because they note thatIPO lock-in arrangements have much “greater variability” than the more“standardised” US practice. Clearly, the expiry of the various moratoria in China’sshare reform programme exhibit some degree of variance. While there aresignificant differences between IPOs and the “Split Share Structure” reformprogramme in relation to the economic significance of the lock-up arrangements, thegeneral principle advanced in Espenlaub et al. (2001) is germane. In verbatim, they notethat:

It is argued that lock-ins may serve to over come adverse selection and agency problemsarising 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 reformprogramme. However, the declared lock-up provisions may be somewhat difficult toquantify in some cases. An example would be where the controlling player not onlydeclares a lock-up arrangement for a particular period but also a minimum price forany 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 March2008), 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 theMoratorium 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 theShanghai Stock Exchange within one year after the Moratorium Period, it will not sell suchshares at less than RMB9.00 per share. In the event that JCC fails to fulfill thisundertaking, all monies received from the disposal [. . .] shall be paid to the account of theCompany (Jiangxi Copper Company Limited, 2006, p. 2, capitalized letters shown asreported).

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

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4. Permissible tradable share combinations: the interplay of A-, B- andH-sharesWhile reform of non-tradable stock into G- and, eventually, into a purely tradable formserves to streamline the equity structure of PRC-incorporated enterprises, manyissuers will still retain other tradable stock types. As reported in Table II, and basedupon data extracted from both HKEx and the CSRC, five possible tradable shareconfigurations apply in relation to mainland-incorporated enterprises. The mostobvious one is a single A-share listing (1,429 issuers). The next, in terms of listingnumbers, is the A- and B-listing combination (86 issuers). 23 issuers also have a singleB- 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. Thislisting was significant because the issuer already had A- and B-share listings in placeprior to its Hong Kong (H-) IPO. Moreover, the controlling shareholder, as explained inits “Global Offering” prospectus document (Shandong Chenming, 2008, p. 100), had itsshare reform proposal accepted by tradable A-investors more than two years prior toits Hong Kong H-share IPO, with a proviso established at that point that it wouldlock-up newly designated shares for a period of 48 months. Consistent with commentsin 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’scompensation package. The Shandong Chenming case, in which a tradable A-, B- and

Issuers withA-sharelistings

Issuerswith

B-sharelistings

Issuerswith

H-sharelistingsa

Shanghai 854 54 –Shenzhen 727 55 –Hong Kong – – 110Total 1,581 109 110Number of listings for the six possible tradable (A-, B- and H-) share configurationsSingle A-listing (Shanghai and Shenzhen combined)b: 1,439 issuersSingle B-listing (Shanghai and Shenzhen combined)c: 23 issuersConcurrent A- and B-listings (Shanghai and Shenzhen combined)c 86 issuersSingle H- listing (H: Hong Kong): 55 issuersConcurrent A- and H-listingsd (H: Hong Kong; and A: eitherShanghai or Shenzhen): 55 issuersConcurrent A-, B- and H-listings (H: Hong Kong; and A: Shanghai): 1 issuer

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 sourceindicated an additional 40 such listings; bDeduced from number of A-share listings (1,581) less numberof issuers with concurrent A- and B-listings (b, 86) less number of issuers with concurrent A- andH-share listings (d, 55 – 1). Shandong Chenming which has triple A-, B- and H-listed status will berepresented in the data twice: in the figure for A- and B-pairings and in the one for A- and H-pairings;cFigures determined from CSRC web site (CSRC (n.d.)). Given an effective moratorium on B-share IPOsin Shanghai and Shenzhen, figures for August 2007 are assumed relevant to October 2008;dFigure obtained courtesy of Hong Kong Exchanges and Clearing Company Limited

Table II.Details of the number of

A-, B- and H-sharelistings in the threerespective Chinese

markets (Shanghai andShenzhen: A- and B-; and

Hong Kong: H-)


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H-combination is apparent, indicates a further tradable stock configuration pattern ontop of the five already discussed.

Perhaps, the most important tradable stock combination is the one relating toissuers (55) with concurrent A- and H-pairings. Issuers within this group representsome of China’s most prominent SOEs (McGuinness, 2008, pp. 112-13), For instance, allof China’s SOE banks, as listed in Hong Kong between 2005 and 2007, have adjoiningA-share listings in Shanghai. This elite group comprises, in descending order of assetsize, ICBC, Bank of China, China Construction Bank, Bank of Communications, ChinaMerchants Bank and China CITIC Bank. In addition, top-ranked Shanghai-listedcompanies such as PetroChina, Sinopec, China Life and China Shenhua all enjoyH-listed status on HKEx. According to figures disclosed on HKEx’s “China StockMarket 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 interms of market capitalization as of 17 October 2008.

As noted at the outset, virtually all controlling shareholders in issuers withtradable 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 withoutaccompanying A-listing), the various share reform provisions do not apply.Domestic stakeholders in such concerns therefore still hold shares in a non-tradableform.

5. Arrangements governing the sale of newly tradable shares and therelated disclosure requirementsWith 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 potentiallyavailable for sale. In the early part of 2008, there were a number of cases wheredomestic shareowners chose to dispose of slices of such holdings. However, the CSRCrecently intervened (in April 2008) to introduce a “block-sale” restriction. The essenceof 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 disposingof 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 acontrolling party holding recently converted shares, through the regular secondarymarket 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 outin the CSRC’s (2005) provisions, highlight the preference for such a disposalmechanism. Specifically, Article 28 states that:

A former non-tradable shareholder to sell a relatively large quantity of shares of a listedcompany 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-sharesconcerns stipulations by the CSRC in July 2008 that the details of any disposals shouldbe made public by disclosing the transactions in a timely manner via China’s SecuritiesDepository Trust & Clearing entity (Ren and Chen, 2008). This second initiative meansthat the selling intention of the disposing party should be quickly signalled to the

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overall market so that any adverse market correction can be quickly transmitted to allmarket participants. The increased transparency from this disclosure measure issurely intended to discourage the hitherto non-tradable stock holders from discretelyselling-down holdings in an incremental fashion.

Implementation of the two pillars – the block-sale restriction and the increasedtransparency surrounding the sale of newly converted stock – is clearly designed todampen the building risk premium relating to state share disposals. These measures,along with others that market authorities might potentially unfurl, have to beinterpreted within the context of the relatively weak market sentiment that nowsurrounds the A-share market, with many tradable A-share prices as of October 2008at levels below 40 per cent of their October/November 2007 peak valuations.

6. ConclusionsThe discussions in this paper help to bring into focus a highly topical issue within thecontext of the Chinese equity market. The various provisions surrounding the eventualmetamorphosis of non-tradable stock into an unfettered tradable form are clearlysignificant and numerous, and include the various lock-up arrangements imposed oncontrolling shareholders, the compensation plans for existing tradable A-shareinvestors, the mobilization of voting rights of tradable A-share investors in relation tothe support of reform proposals, the recent CSRC-initiative in introducing block-salerestrictions and, finally, measures to increase transparency surrounding the sale ofrecently converted shares.

For certain issuers, a discernible risk premium has been building in the last year asparticular parts of the moratoria imposed on controlling stakes have either lapsed orare set to do so in the very near future. While this raises the spectre of large-scalestate-share disposals, the amount of activity in this area is likely to be heavilyconstrained 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 andstream-line the old share configuration of the PRC-incorporated SOE.

Nonetheless, some significant disposal activities will inevitably occur. Priorrelated evidence in Chen et al. (2008), for transfers of controlling non-tradable stakes inSOE listed issuers between 1996 and 2000, points to positive earnings and stock priceeffects when domestic controlling stakes are acquired by private investors.While disposals (or transfers) through the reform programme will be carefullyscrutinized, the results in Chen et al. offer some comfort for existing tradable A-shareinvestors. On a less positive note, Chen et al. (2008) found that earnings and stock pricegains were generally not apparent for sales of parcels of stock between state-relatedparties.

While the reform is highly significant in terms of its remit, extending to over 1,500A-listed issuers, it does nothing to streamline the various tradable share types (A-, B-and H-) that currently exist. Even though the majority of listed issuers only have asingle A-share listing, the largest and perhaps most important of SOEs haveconcurrent A- (Shanghai) and H- (Hong Kong) listings. Pricing differences between thetwo sets of stocks, largely as a result of trading restrictions brought-on by capitalaccount restrictions relevant to mainland China, suggest that an attempt to merge thetwo 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 willcontinue to serve separate sets of investors. As for the B-shares, rumours circulate fromtime-to-time as to possible further reform of the market. In a practical sense, the smallnumber of issuers and the relatively small float and market capitalization size of theB-market, mean that the authorities may continue to resist enlarging the market, andtherefore extend the effective moratoria on B-share IPOs into perpetuity. With moreand more listings wending their way through to the Shanghai and Shenzhen A-sharemarkets in coming years, the B-share market will likely be further marginalized interms 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 2001mainland PRC resident investors, with approved foreign exchange accounts, have been ableto trade in the market. Prior to this, the B-share market was legally confined to tradesbetween foreign investors (i.e. Hong Kong and other non-mainland Chinese investors). Fordetails 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 futureresearch.

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Fei, L., Balatbat, M. and Czernkowski, R. (2008), “The reform of split share structure in China andits 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).

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Jiangxi Copper Company Limited (2006), “Announcement adjusted share reform plan proposedby 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’slisted companies”, Journal of Corporate Law Studies, 2008, April, pp. 57-78.

Leland, H. and Pyle, D. (1977), “Information asymmetries, financial structure and financialintermediation”, Journal of Finance, Vol. 32, pp. 371-87.

Li, K., Wang, T., Cheung, Y-L. and Jiang, P. (2008), “Privatization risk sharing: evidence from thesplit share structure reform in China”, available at: http://webapps2.ucalgary.ca/ , nfa99/openconf/papers/230.pdf

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O’Neill, M. (2005a), “China state share sale spooks market: regulator names four companies tostart revived scheme”, South China Morning Post, Business, 10 May, p. B1.

O’Neill, M. (2005b), “China hastens sale of state shares; officials rule out compensationfor 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 PaperHoldings, 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, noticeposted 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 shareholdersconcerning the share reform scheme”, China Petroleum & Chemical Corporation, noticeposted on HKEx web site, available at: www.hkexnews.hk/listedco/listconews/sehk/20060906/LTN20060906055.pdf (accessed 5 September).

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Corresponding authorPaul B. McGuinness can be contacted at: [email protected]

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Market risk disclosure: evidencefrom Malaysian listed firms

Radiah OthmanResearch Management Institute, Universiti Teknologi Mara, Shah Alam,

Malaysia, and

Rashid AmeerFaculty of Accountancy, Universiti Teknologi Mara, Shah Alam, Malaysia

Abstract

Purpose – The purpose of this paper is to investigate the market risk disclosure practices amongMalaysian listed firms. Specifically, it aims to examine the level of compliance with FRS132: FinancialInstruments – 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 relationto disclosing the financial risk management policy, there are systematic differences across companiesin terms of level of details (i.e. qualitative and quantitative) disclosure. Interest rate disclosure was themost mentioned category and the credit risk was the least mentioned category of market risk. There istelling evidence that most Malaysian firms did not engage in hedging any type of market risk over thereporting period of 2006-2007.

Research limitations/implications – There is a need for some standardized risk reporting formatto 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 ofderivatives instruments by listed firms in Malaysia.

Keywords Disclosure, Financial reporting, Malaysia, Financial risk


1. IntroductionEstimation, presentation and dissemination of financial risk measures are the basis ofrisk reporting by financial institutions and other organizations (Holt, 2006). Raghavanand Li (2006) argue that the structural economic environment and the regulatorychanges have led to the evolution of the both qualitative and quantitative market riskreporting by the organizations. Market risk is defined as the risk of loss arising fromadverse changes in market rates and prices such as interest rates, currency exchangerates, commodity prices, or equity prices. Derivatives are an integral part of marketrisk management policy. Derivatives are typically off-balance sheet items. Theiraccompanying rights and obligations (and hence gains and losses) usually circumventfinancial statement disclosure. In the absence of disclosure of these off-balance sheetitems, it has been argued that investors’ are unable to assess all factors that affect afirm’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 ofthe existence of disclosure related, or proprietary, costs. Firms may not like to discloseextensive information that might have future repercussions for their bare existence dueto sensitivity of such information.



Market riskdisclosure

57


Vol. 17 No. 1, 2009pp. 57-69


DOI 10.1108/13581980910934045

This paper investigates the market risk disclosure of the firms listed on the threeboards – main, second and MESDAQ boards in Malaysia, respectively, for the reportingperiod of 2006-2007 (2006 is the first reporting period following the release of the FRS132or alternatively Malaysian Accounting Standards Board – MASB 24). We believe thatthis 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 notexplore the compliance with one FRS standard in particular. Our paper is similar toTalha et al. (2007) who examined the competitive disadvantage of segmental disclosurefor sample of 116 firms under the requirement of MASB 22 Segment Reporting, and therisk reporting issues in Islamic Banks in Malaysia examined by Ariffin (2004).

The following section discusses the specific requirements of the FRS132, while theensuing sections discuss and illustrate the format, location, and flexibility in providingdisclosure. After discussing the requirements, we then identify the research questionsfollowed by the results and discussion of the analysis.

2. Institutional setting in MalaysiaThe MASB (2005) is the standard setting body for Financial Reporting Standards(FRS), including standards for Islamic accounting and reporting in Malaysia. Prior tothe setting up of the MASB, the accountancy bodies of the Malaysian Institute ofAccountants and Malaysian Institute of Certified Public Accountants collaboratedand issued FRS. The situation changed when in 2005, when MASB renamed andrenumbered the MASB standards to FRS. This is to be in line with the objective of theInternational Accounting Standard Board, of which Malaysia is a member, to worktowards convergence to a single set of accounting standards worldwide, (known as theInternational Financial Reporting Standards (IFRS). As MASB standards wereadoption of IAS, there were no major areas of differences between the standards whenthe MASB standards were renumbered and renamed to FRS (Lazar et al., 2006). MASBintroduced FRS132: Financial Instruments – Disclosure and Presentation (IAS32) forthe first time to be adopted by Malaysian firms for financial periods beginning or after2006. This standard exposes the type of market risk being faced by listed companies inMalaysia, 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 therecognition and measurement of financial assets and financial liabilities but itsimplementation date has not been announced yet.

2.1 FRS132 disclosure requirementsFinancial instruments include financial assets and financial liabilities. Financial assetsrepresent a contractual right to receive cash in the future and correspondingly financialliabilities represent a contractual obligation to deliver cash in the future. Derivativefinancial instruments meet the definition of the financial instrument because thesecreate rights and obligations that have the effect of transferring between the parties tothe instrument one of more of the financial risks inherent in an underlying primaryfinancial instrument. Derivative financial instruments are used by firms for riskmanagement purposes such as foreign exchange forward contracts, interest rate swaps(IRS), foreign currency swaps among others. On inception, some derivativeinstruments such as foreign currency swaps, embody both a right and obligation tomake an exchange of foreign currencies in future, and as exchange rate changes those

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terms may become either favorable or unfavorable represents the financial gain (loss)to the firms.

According to paragraph 56 of FRS132 Financial Instrument – Disclosure andPresentation, there is a specific requirement that an entity shall describe its financialrisk management objectives and policies, including its policy for hedging each maintype of forecast transaction for which hedge accounting is used. Similarly paragraph58 of FRS132 Financial Instrument specifies that an entity shall disclose a descriptionof hedge; nature of risk being hedged, and a description of the financial instrumentsdesignated as hedging instruments and their fair values at the balance sheet date. Foreach type of market risk such as interest rate risk, an entity shall disclose informationabout its exposure to interest rate risk, including effective interest rates and maturitydates (or contractual re-pricing). On the other hand, for credit risk an entity shalldisclose the amount that best represents its maximum credit risk exposure as atbalance sheet date, without taking into account of the fair value of any collateral, in theevent of other parties failing to perform their obligations under financial instruments,and significant concentration of credit risk.

2.2 Format, location and flexibility in disclosureThe standard prescribes that the disclosure may include a combination of narrativedescriptions and quantified data, as appropriate to the nature of the instruments andtheir relative significance to an entity. For instance, information about an individualfinancial instrument may be important when it is a material component of an entity’scapital 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 formatWhen hedging instruments held or issued by an entity, either individually or as a class,creates a potentially significant exposure to the foreign exchange, commodity andinterest rate risks. Their terms and conditions that warrant disclosure are: theprincipal, 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 theconversion or exchange ratio.

2.4 Interest rate risk disclosure formatThe carrying amount of financial instruments exposed to interest rate risk maybe presented in tabular form, grouped by those that are contracted to mature or bere-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 notmore than three years; in more than three years but not more than four years; in morethan fours but not more than five years; and more than five years. Interest rateinformation may be disclosed for individual instruments, or weighted average rates ora range of rates may be presented for each class of financial instrument.

2.5 Credit risk disclosure formatThe disclosure of the financial assets exposed to credit risk shall include thecarrying amount of the assets in the balance sheet, net of any provisions for loss.


59

For example, in the case of an IRS carried at fair value, the maximum exposure to lossat the balance sheet date is normally the carrying amount because it represents thecost, 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 financialliability shall be disclosed. It is intriguing to learn that even though MASBadvise companies to disclose liquidity risk but no format has been suggested to date.We present evidence from Malaysian firms because there has been no comprehensivestudy on market risk disclosure. Furthermore, it has been suggested that the marketrisk disclosure is a topic of great economic significance given the scale of globalderivative trading (Seow and Tam, 2002).

Previous studies on the market risk disclosure (primarily in the USA) have eitherfocused on the different categories of market risk individually, or examined all suchmarket risks but focusing on the nature of disclosure, i.e. qualitative and quantitative. Forinstance, Rajgopal (1999) examined the commodity price risk exposure of oil and gasproducers, while, Blankly et al. (2002) examined the qualitative and quantitative marketrisk disclosure under SEC requirement. Recently, attention has shifted towardsinvestigating the compliance with a particular derivatives reporting standard.Abdelghany (2005) examined quantitative and qualitative disclosure of market riskunder FFR No. 48, and Bhamornsiri and Schroeder (2004) examined disclosure ofinformation on derivatives under SFAS No. 133 using sample of DOW30 companies. Somestudies have empirically investigated the value relevance of market risk disclosure (Limand 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 risksquantified using value-at-risk technique as suggested by Choudry (2001), whereas Seowand Tam (2002) examined the relationship between share returns and the quantitativedisclosure 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 riskmanagement disclosure using 10-k filings. They find propensity of companies to use VaR,has been associated with greater use of derivatives and concerns about losingcompetitiveness from revealing proprietary information, whereas, propensity to usetabular method of presentation has been associated with greater exposure of interest rateand commodity risks as well as greatest demand for external financing.

Other non-US studies are – Linsley and Shrives (2006, 2005, 2000) and Abrahamand Cox (2007) for the UK. Linsley and Shrives (2006) found that there is a significantassociation between the number of risk disclosures and company size for 79 UK listedfirms; and the most important benefit arising from improved risk disclosure by firms isa reduction in the cost of capital. They argue that if the market risks are disclosed, thenthe providers of capital may remove a part of the premium that is incorporated in thecost 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 preferencefor firms with lower level of risk disclosure (which also include internal risk controlreporting). Kajuter (2001) found lack of systematic risk disclosure of Germancompanies under the German Accounting Standard 5 “Risk Reporting”, which becameeffective after 31 December 2000. Beattie et al. (2004) examined in detail the narrative offorward looking risk-related disclosure in the UK using content analysis. Beretta andBozzolan (2004) found significant relationship between firm size and risk disclosure forItalian firms.

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

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

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 minimizemarket risks?

RQ5. Do companies provide qualitative and/or quantitative disclosure relating tothe hedge instruments for each type of market risk?

RQ6. Do companies provide additional voluntary disclosure on other market risks?

4. Sample and methodologyThe population consists of all firms listed on the main, second and MESDAQ boards ofBursa Malaysia. We selected top 500 firms ranked by market capitalization as of yearend in 2005. The information on adoption (or otherwise) of FRS132 by these firms wasobtained from their annual reports for the financial year ended in 2006/2007. In somecases, we did not obtain annual report of the companies in English language from theirinvestor relation Webpage, Company Announcement Page, and Audited AccountsPage of Bursa Malaysia, which reduced the number of sample to 429 firms. The finalsample of companies according to listing board classification is described in Table I.

There is relatively higher number of companies from main board, followed by firmsfrom the second board. There are a lower number of firms from MESDAQ in the sample.The annual reports were downloaded from Bursa Malaysia Company AnnouncementWebpage 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 reportof a firm was not available from Bursa Company Announcement page, we downloadedthe latest annual report for the year ended in 2006/2007 from firm web site to execute oursearch. We found that these key terms were found in the section titled “Financial RiskManagement 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

Listing boardMain board Second board MESDAQ Total

Overall 241 89 115 445Annual reports available for either 2006or 2007 in English language 228 89 112 429

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

Table I.Sample classification


61

disclosure – interest rate risk, foreign exchange risk and credit risk; type of hedgeinstrument used to hedge interest rate and foreign exchange risk, quantitative disclosurerelated to hedge instrument amount, currency denomination, maturity, and reported profit(loss) using a nominal coding procedure (Appendix for detail). This coding procedureeffectively leads to 0 and 1 dummy type variables for descriptive analysis andtherefore overcomes the problem associated with counting words in a sentence (Abrahamand Cox, 2007).

5. ResultsWe present results of our investigation according to questions mentioned above(and where necessary a distinction among companies based on their listing board isprovided 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 withFRS132 in relation to disclosing financial risk management policy. The compliance levelamong 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 listedbanks) 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 statethat they do not engage in speculative or trading activities in their financial riskmanagement statement (see below), the number of such firms varies from a high of 90on the main board to a low of 25 on the MESDAQ board:

The Group uses derivative financial instruments in the form of forward foreign exchangecontracts and interest rate swap contracts to hedge its exposure to foreign exchange arisingfrom 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).

Listing boardMain board(per cent)

Second board(per cent)

MESDAQ(per cent) Total

Financial risk management statement and policyYes 189 (82.90) 61(68.54) 78 (69.64) 328No 39 (17.10) 28 (31.46) 34 (30.35) 101Total number of firms 228 89 112 429Hedging objectiveSpeculative 11 (4.82) – – 11Non-speculative 90 (39.47) 25 (28.09) 33 (29.46) 148No-disclosure 127 (55.70) 64 (71.91) 79 (70.54) 270Total number of firms 228 89 112 429

Note: This table reports the number of firms providing financial risk management and policy in theirannual report for the financial year ending 2007 according to their listing on the main, second andMESDAQ boards, respectivelyTable II.

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

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 ofqualitative 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, acrossthe listing boards, we can conclude that interest rate disclosure was the most mentionedcategory and the credit risk was the least mentioned category of market risk. MESDAQhas the highest proportion of firms without any disclosure on foreign exchange risk andsecond board has almost no firm in our sample disclosing credit risk.

The latter finding might seem to suggest a belief among companies that credit riskinformation was immaterial and therefore need not to be disclosed. We also furtherexplore the qualitative and/or quantitative components of risk disclosure. It wasnoticed that overwhelming majority of the companies have followed MASB guidelineson reporting interest rate risk. The interest rate risk is shown as, re-priced in thefollowing periods after the balance sheet date in one year or less and in more thanone year but not more than two years; in more than two years but not more than threeyears; in more than three years but not more than four years; in more than fours but notmore than five years; and more than five years. Interest rates information are disclosedfor individual instruments, effective and/or weighted average rates or a range of ratesare presented for each class of financial instrument (Table IV).

On the other hand, a relatively small proportion of companies have only relied onthe qualitative narratives for the interest disclosure:

Listing board

Market risks disclosureMain board(per cent)



Foreign exchange riskYes 93 (40.53) 35 (39.30) 26 (23.00) 154No 135 (59.47) 54 (60.70) 86 (77.00) 275Total number of firms 228 89 112 429Interest rate riskYes 101 (44.30) 25 (28.09) 33 (29.46) 159No 127 (55.70) 64 (71.91) 79 (70.54) 270Total number of firms 228 89 112 429Credit riskYes 13 (5.70) – 9 (8.04) 111No 215 (94.30) 89 (100) 103 (91.96) 318Total number of firms 228 89 112 429

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


63

The Group’s policy on managing its interest rate risk is by maintaining a prudent mix offixed 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 inhedging market risk, i.e. 290 (67.6 per cent) firms have not reported use of either aforward, swap, option, and/or futures contract over the reporting period of 2006-2007 inour sample. Overall, 18 per cent of the Malaysian listed firms in our sample useforward contract for the transaction exposure which is relatively lower than 31 per centfor 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 thanreported for the UK firms (18.90 per cent):

RQ4. Do companies disclose the type of hedging instrument used to minimizemarket 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 useof hedge instruments. Among the main board firms, forward contracts are used in high

At 31 October 2006

Effectiveinterest rates

(per cent)Within

one yearOne to five

yearsMore thanfive years Total

Financial assetFixed deposits with licensed banks 2.50-3.70 2,692,900 2,692,000Financial liabilitiesBankers acceptances 3.50-5.28 95,982,578 – 95,982,578Bank overdrafts 7.00-8.00 9,299,753 – 9,299,753Hire purchases liabilities 3.20-6.54 231,898 416,151 648,049Term loans 7.50-7.75 2,171,274 2,528,061 4,699,335Trust receipts 7.25 4,500,000 – 4,500,000

Source: JAKS Resources Bhd (2006)Table IV.

Listing board

Hedging instrumentMain board(per cent)



Forward contract 61 (26.80) 11 (12.40) 5 (4.50) 77Swaps contract 13 (5.70) – – 13Forward and swaps contract 10 (4.40) – – 10Forward and options contract 1 (0.40) – – 1Forward, swaps, and options contract 8 (3.50) – – 8Forward, swaps, and futures contract 2 (0.90) – – 2Natural hedge 13 (5.70) 8 (9.00) 7 (6.25) 28Does not use any hedge instrument 120 (52.60) 70 (78.60) 100 (89.25) 290Total number of firms 228 89 112 429

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

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proportion to hedge market risks followed by swap, and/or both forward and swapcontracts. Besides, forward and swap contract, it was found that natural hedge (aninternal hedging technique) is also being employed by the firms across three boards. Anatural hedge consists of matching inflows and outflows with respect timing ofsettlement in the same currency.

Table VI shows that 83 firms have used forward contracts for foreign exchange andinterest 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 securityagainst future foreign exchange rate uncertainties, then one would expect their use to bemore strongly associated with the foreign currency exposure. We used a x 2 test to testthe null hypothesis of no association between utilization of forward contracts andhedging 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 associationappears to be higher. On the other hand, foreign exchange futures contracts are not usedby firms. Joseph (2000) suggests that low-utilization level of futures contracts may bedue to the effects of daily resettlement which can adversely affect the liquidity of firms:

RQ5. Do companies provide qualitative and/or quantitative disclosure relating tothe hedge instruments for each type of market risk?

We find that nature of market risk disclosure in terms of qualitative and quantitativedetail is not similar across firms. Those firms which report using derivative contractssuch as forward contracts provide mainly quantitative disclosure. Examples ofquantitative disclosure on the amount, denomination, maturity and profit (loss) forforeign exchange contracts and IRS are as shown in Tables VII and VIII.

Table VII shows the foreign currency forward contracts which have been entered bythe group for its trade receivables and trade payables.

The group has entered into IRS to convert floating rate liabilities to fixed rateliabilities and vice versa to reduce the group’s exposure from adverse fluctuations ininterest rates on underlying debt instruments, as shown in Table VIII.

Listing boardMain board Second board MESDAQ

Hedginginstrument

Interestrate risk

Foreignexchange

riskInterestrate risk

Foreignexchange

riskInterestrate risk

Foreignexchange

risk

Forward contract 5 58 – 11 4 5Swaps contract 12 3 – – – –Forward and swapcontract 9 10 – – – –Forward, swap,option, futuresa 8 11 – – – –Natural hedge – 13 – 8 – 6Total number offirms 34 95 – 19 4 11

Notes: This table reports the number of firms using hedge instrument for controlling interest rate andforeign 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.


65

Interest rate swaps

Notional amount inRM (and equivalentin US$) Effective period

Weighted averagerate p.a.

US$ term loan RM 741.30 million(equivalent toUS$210 million)

28 February 2006 to28 February 2008

4.98-5.15 per cent forthe entire tenor ofliability


4.98-5.00 per cent forthe entire tenor ofliability provided thespread is in range

US$ term loan RM 529.50(equivalent toUS$150 million)


4.795-5 per cent forthe entire tenure ofliability


Floating but cappedat 6 per centprovided the sixmonth LIBOR iswithin the specifiedranges

US$ term loan RM 34.59 (equivalentto US$9.8 million)

27 July 2006 to 26July 2010

6.425 per cent for theentire tenor ofliability

US$ term loan RM 34.50 (equivalentto US$9.8 million)

27 July 2006 to 26July 2007

5.6 per cent for theentire tenor ofliability

27 July 2007 to 26July 2010

5.6 per cent for theentire tenor of theliability, providedthe spread is withinthe range

Ringgit five-sevenyear Islamic bond

RM 40 million 28 February 2006 to28 February 2008

Six monthsKLIBOR þ 1.80per cent

Source: Kumpulan Guthrie Bhd (2006)Table VIII.

2007 Amount in foreign currency (FC) Contractual rate 1 FC/RM Maturity

US$ 285,000 3.4780 2 July 2007Sterling £ 13,200 6.9150 9 July 2007US$ 2,115,903 3.4830 12 July 2007Sterling £ 128,063 6.7650 16 July 2007e 117,806 4.6375 31 July 2007US$ 66,971 3.3805 1 August 2007US$ 69,545 3.4270 3 September 2007e 60,528 4.6330 14 September 2007US$ 184,939 3.4550 20 September 2007US$ 24,209 3.4550 28 September 2007

Source: Dialog Group Bhd (2007)Table VII.

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Some firms which choose to combine both qualitative and quantitative disclosure onthe amount, denomination, and maturity for derivatives:

In April 2007, the Company entered into four swap transactions, each in a notional amount ofUSD55.0 million, and amounting to an aggregate amount of USD220.0 million, with theobjective 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 withupfront savings to the Company, and depending on the individual structure, losses arecapped at between 1.75 per cent and 3.50 per cent per annum, in order that any exposure ofthe Company is limited. On two of the swaps, Ranhill is obliged to pay a fixed interest rate of3.50 per cent and 3.35 per cent per annum in USD and is entitled to receive a floating interestrate per annum in USD, on a semi-annual basis, in April and October of each calendar year totermination. On the other two remaining swaps, Ranhill is obliged to pay a floating interestrate per annum in USD and will receive a fixed interest rate of at least 12.50 per cent perannum in USD on a semi-annual basis in April and October of each calendar year totermination (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 othercategories of market risk for example:

The Group is exposed to a significant concentration of credit risk, whereby significantoutstanding 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 (PadiniHoldings Bhd, 2006).

The Group’s investments in quoted securities are subject to fluctuations in market prices. Asand when necessary, the group should consider and if found to be feasible, engage in KLCIFuture purely for hedging purposes to mitigate the impact arising from the fluctuations inmarket price (MNRB Holdings Bhd, 2006).

The market risk of the Group’s trading and non-trading portfolio is managed usingvalue-at-risk approach to compute the market risk exposure of non-trading and tradingportfolio. Value-at-risk is a statistical measure that estimates the potential change in portfoliovalue that may occur brought about by daily changes in market rates over a specified holdingperiod at a specified confidence level under normal market conditions. For the Group’strading portfolio, the Group’s value-at-risk measurement takes a more sophisticated form bytaking into account the correlation effects of various instruments in the portfolio (AMMBHoldings Group Bhd, 2006).

6. ConclusionThe aim of this paper is to investigate the market risk disclosure practices amongMalaysian listed firms under FRS132: Financial Instruments – Disclosure andPresentation, following its adoption in the year 2006. Our results show that thoughmajority of the firms studied (328 out of 429) had complied with FRS132, the extent ofcompliance varied. The majority did not state whether they engaged in any speculativeactivities using any hedging instrument. Interest rate disclosure was favored ascompared 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 usedto minimize market risk. Our finding seems to suggest that the type of hedginginstrument 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 amongMalaysian firms reflects the critical need for some standardized reporting format orguidelines from the standard setting and regulatory bodies. While compliance isimportant; there is a greater need for financial transparency on market risk to cater theneeds of various stakeholders. This is to ensure that financial information is of valueand relevance, to the people relying on such disclosure.

Notes

1. In the US, SFAS Nos. 80, 105, 107, 119, and 133 were issued progressively requiringinformation on derivative notional principal amount, credit exposure, fair value and gain orloss.

2. Bhamornsiri and Schroeder (2004) have also used a similar approach to examine qualitativeand 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 empiricalstudy”, Managerial Auditing Journal, Vol. 20 No. 8, pp. 867-75.

Abraham, S. and Cox, P. (2007), “Analysing the determinants of narrative risk information in UKFTSE 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, AMMBHoldings Group Bhd, Kuala Lumpur.

Ariffin, N. (2004), “Transparency in Islamic banks: risk reporting issues”, paper presented atIIUM Accounting Conference II, Kuala Lumpur.

Beattie, V., McInnes, W. and Fearnley, S. (2004), “A methodology for analysing and evaluatingnarratives in annual reports: a comprehensive descriptive profile and metrics fordisclosure 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 underSFAS 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, PetalingJaya.

Emm, E.K., Gay, D.G. and Lin, C-M. (2007), “Choices and best practices in corporate riskmanagement 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 ManagementA Modern Perspective, Academic Press/Elsevier, Burlington, MA, pp. 607-31.

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Hu, C. and Wang, P. (2006), “The determinants of foreign currency hedging – evidence fromHong 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 industrialfirms”, Journal of Multinational Financial Management, Vol. 10, pp. 161-84.

Kajuter, 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 GuthrieBhd, Kuala Lumpur.

Lazar, J., Tan, L.L. and Othman, R. (2006), “Adoption of international financial reportingstandards – 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 ofQuantitative Finance and Accounting, Vol. 29, pp. 353-70.

Linsley, M.P. and Shrives, J.P. (2000), “Risk management and reporting risk in the UK”, Journalof 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 annualreport 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 andPresentation, 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 AccountingReview, 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 segmentdisclosure: 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 ofAccounting and Economics, Vol. 22, pp. 327-55.


69


LEGAL COMMENTARY

Extent to which financial servicescompensation scheme can pursueclaims assigned to it by investors

whom it has compensatedJoanna 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 fromclaims being pursued by the Financial Services Compensation Scheme (FSCS) against Abbey NationalTreasury 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 andalleged that ANTS had collaborated with NDF in product development and promotion of theStructured Capital at Risk Products and was liable in negligence and misrepresentation to theinvestors whose claims it held as assignee. Having considered the arguments, the Judge concluded thatFSA 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 jurisdictionthat 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.

FactsThis was a trial of two preliminary issues only that themselves arose from claimsbeing pursued by the Financial Services Compensation Scheme (FSCS) against AbbeyNational Treasury Services (ANTS) and NDF Administration Ltd (NDF). Those claimshad in turn been assigned to FSCS by some 1,800 individual retail investors who hadreceived compensation from FSCS in respect of mis-selling claims against IndependentFinancial Advisers (IFAS) which were unlikely to be met by the IFAS concerned.The factual background to those original claims against the IFAS was brieflydescribed 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 begreater or less than the initial investment depending on the performance of the index, but itwas geared in the case of most of the products, so that there might be a reduction of 2 per cent



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or more for every 1 per cent fall in the index. There are 14 types or series of such products inissue in the action.

FSCS has compensated approximately 1,800 retail investors in respect of losses suffered bythem as a result of investing in one or more of the products between 1999 and 2002. All of theinvestors invested in the products after receiving a mailshot and/or tailored advice from anIFA, 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 groundsthat the degree of risk under the products was not explained (or was misrepresented) to themby their IFA. FSCS determined that because of their financial circumstances, the IFAs wereunable or were likely to be unable to meet the investors’ claims, and accordingly FSCSdeclared 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 theirclaims against third parties such as ANTS and NDF.

The products were promoted by NDF, with which the investor contracted. The proceeds ofthe products were invested in shares in an investment company established for the purposeand listed on the Dublin Stock Exchange. ANTS did not deal directly with investors but itcreated the products. It was responsible for establishing the investment company, acted as itsinvestment adviser and was the counterparty which entered into an index swap transactionor equity linked deposit transaction with the investment company.

NDF was subject, as regards its promotion of the products, to the relevant rules made firstunder the Financial Services Act 1986 (the 1986 Act) and, in relation to promotion after 1December 2001, by the FSA under FSMA. FSCS contends that the marketing material for theproducts failed to make clear the risks associated with them and that investors were inducedto invest in the products in reliance on misleading statements and material omissions. Its caseis that if the marketing material had, as it puts it, fairly disclosed the degree of risk in theproducts, the investors would not have invested in them. It claims that NDF was in breach ofthe applicable rules regulating the contents of marketing material and its claims against NDFare 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 promotionof the products and in marketing them to investors through IFAs. The claims are innegligence and misrepresentation and, by reason of a joint enterprise with NDF, breach ofstatutory duty. ANTS denies any liability. It pleads that the plans and promotional materialwere issued by NDF, and that it is a wholesale institution which has not given investmentadvice to retail investors or issued promotional material, whether as regards the products orotherwise.

The assignment of the claims was effected by the signature of those investors whowere compensated by FSCS of terms governing the payment of that compensationwhich included the following provisions:

[Section 3.4] We/I confirm that we/I have received no offer or payment of compensation of anykind in respect of the losses for which compensation is sought herein whether from the firm orany other person. We/I also confirm that we/I do not expect to receive any such compensationin the future. Any such payment of compensation received by us/me, we/I will pay to theFinancial 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, takeover 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 andacknowledgment 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 asprovided in the said Section 4 [. . .]

[Section 4.2] That all our/my rights against the firm in respect of the Protected Claim shallpass to and be assigned to the FSCS Limited absolutely on payment of compensation (or anypart 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 Limitedabsolutely on payment of compensation (or any part thereof) pursuant to the Rules and/or theOrder.

4.4 That upon payment of compensation (or any part thereof) we/I will no longer have theright to make any claim against the firm or any other such person in respect of the ProtectedClaim or any Third Party Claim, and that the right to make any such claims will be vested inthe FSCS Limited pursuant to the Rules and/or the Order. We/I further acknowledge that anysuch 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 orscheme 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 regardingclaims 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, ifrelevant, 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 theFSCS Limited from time to time to give full effect to the vesting in it of all rights and claimsunder and for the purpose of this agreement. Insofar as any assignment provided for herein isineffective in law or equity to vest any rights or claims in the FSCS Limited, the FSCS Limitedwill be subrogated to those rights or claims, and will be entitled to the proceeds of theProtected Claim and any Third Party Claim. All such proceeds will be paid to the FSCSLimited.

4.13 In this document, “Third Party Claim” means any right, claim or cause of action whichthe claimant has or may have against any other person than the firm or against any fund orproperty in the hands of any person other than the firm and arising out of the circumstancesgiving rise to the Protected Claim or otherwise relating to that claim, whether such claimsshall arise in debt, breach of contract, tort, breach of trust or in any other manner whatsoever.

ActionThe FSCS commenced action against ANTS as assignee of the assigned claims andalleged that ANTS had collaborated with NDF in product development and promotionof the Structured Capital at Risk Products and was liable in negligence andmisrepresentation to the investors whose claims it now held as assignee. FSCS alsoalleged that ANTS was liable jointly with NDF for breach of statutory duty in relationto these assigned investor claims. ANTS denied these claims but before they could betried in substance the Judge had, on application of both parties, ordered the followingtwo preliminary issues to be resolved:

(1) Whether the assignments of investors’ claims against ANTS referred to inparagraphs 2 and 3 of the particulars of claim are void and ineffective on theground that FSCS had no power to agree such assignments.

(2) Whether the compensation paid by FSCS to investors is to be taken into accountin the calculation of the loss recoverable by FSCS as assignee of the investors’claims against ANTS.

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DecisionIn relation to the first of the two issues, the Judge saw the key question as beingwhether Part XV of the Financial Services and Markets Act 2000 conferred power onthe FSA to include in its rules which it made to establish and operate the FSCS anyprovision for assignment to it by investors of claims against third parties. For, ofcourse, these third parties were not the same regulated person or persons whose defaultand inability to meet investor claims had led the investors to claim compensation fromthe FSCS in the first place. For if the Financial Services and Markets Act 2000 did notconfer such rule-making power then FSA had acted ultra-vires in making the rulespursuant to which it took assignment of these investors’ claims against ANTS andNDF.

The Judge examined the terms of the various statutory provisions within FSMA2000 and the Insolvency Act 1986 which applied to the rules and guidance that FSAhad made in relation to the FSCS which form part of the FSA Handbook of Rules andGuidance. These included Section 54 FSMA 2000 which enables the FSA to establishsuch a scheme for compensation of certain investors, Part XV (Sections 213-217) FSMA2000 which gives more detail as to how the FSA may make provision for and operatesuch a scheme and the general power conferred on the FSA to make rules contained inSection 156 FSMA 2000. He also reviewed and analysed in some detail both thestatutory history of Part XV FSMA 2000 and certain of the predecessor sector specificcompensation schemes which it replaced and consolidated, as well as case law to datewhich had dealt with issues concerning investor claims assigned to the InvestorsCompensation Scheme (Investors’ Compensation Scheme Ltd v. West BromwichBuilding Society, Investors’ Compensation Scheme Ltd v. Hopkin & Sons (a firm),Alford v. West Bromwich Building Society, Armitage v. West Bromwich BuildingSociety [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 thepredecessor schemes to the FSCS and had been established under the FinancialServices Act 1986.

Having considered the arguments made for ANTS and for FSA in relation to thevalidity of the power of FSA to make rules enabling FSCS to take assignment ofinvestor claims the Judge concluded that FSA did have such a power for the followingreasons:

While such a provision is not an essential component of a compensation scheme, it is in myview an obvious provision and one which can properly be regarded as integral, rather thanperipheral, to it. There is a clear connection between the payment of compensation wheredefendant A is unable to meet the claim and the assignment to the scheme manager not onlyof the claim against defendant A but also of claims for the same or largely the same lossagainst defendant B. It is, I would suggest, a provision which any reasonable person wouldregard as an obvious way in which the scheme could seek to recoup some or all of thecompensation which it had been required to pay. I consider that the power to make suchprovision falls within Section 213(1) [FSMA 2000], but if I am wrong about that, it is in myview an incidental or supplemental matter within Section 156(2) [. . .]

The Judge now turned to the second of the two issues for resolution in theseproceedings – whether the claim being pursued by FSCS against ANTS should be foran amount of damages nett of the compensation already paid by FSCS to the investorswho 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 actualfinancial difference, this would make to the potential liability of ANTS to FSCS inrespect of these claims it was clear and accepted by both parties that the difference inlevel of recovery achievable by FSCS against ANTS was very considerable. Counsel forANTS had argued that without deduction of the compensation already paid the lossesclaimed for could be £21 million but if the court insisted that the losses take intoaccount 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 achieveon these assigned claims? Counsel for ANTS had argued that to allow the claims to bepursued gross would be to allow for double recovery for the investors while counsel forthe FSCS had argued that the whole purpose of having investor claims assigned to itwhen it paid out compensation to investors was in order to enable it to recoup the costsof such compensation by pursuing those claims in respect of which compensation waspaid, against third parties if need be.

The Judge considered the effect of the terms of the assignment agreement betweenthe FSCS and those investors to whom it had already paid compensation. He also tookinto account those FSCS rules which require it to pay any surplus recovery over andabove 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 canrecoup its outlay. To give effect to this purpose it is necessary that there is assigned the grossclaim, as is clearly the intention from [the FSCS rules and the assignment agreement he hadconsidered] The inclusion of [such] provisions [. . .] are necessarily part of a scheme designedto achieve that purpose. [. . .] It would be an extraordinary position if the purpose of theassignment as set out in the scheme rules, both in terms of recouping FSCS and paying anysurplus to the investors, would be defeated by an inability to include the provisions necessaryto give effect to it.

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

CommentClearly, 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 inevery jurisdiction that has them. This is because not just of the considerable costs andpotential costs of such schemes but also the inevitable element of cross-subsidyinherent in those schemes funded by industry levies, as the FSCS is.

This point was raised in the context of assignment of investor claims in theInvestors Compensation Scheme Ltd v. West Bromwich Building Society case andadverted 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 aclass of members of the public, that there should also be established an efficient system forthe compensating authority to be able to recover from all persons whose misconduct hasled to such compensation being necessary, contributions or indemnity to cover thecompensation paid.

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The reasoning revealed in those words was approved by the Judge in this case too ashe outlined the benefits for those levy payers that fund FSCS in allowing the FSCS topursue recoveries that appear reasonably possible and cost-effective. He stated thatsuch pursuit of assigned claims by FSCS would be likely to be welcomed by innocentlevy payers who would be presumed to rather see the costs of compensation paid bythe scheme falling on third parties whose culpable acts and omissions had led orcontributed to the claims in respect of which such costs arose. As claims on the FSCScontinue to mount in the current climate for retail financial services and its fundingcosts grow in consequence, there will not be many regulated firms in the industrywhich bear those costs who will disagree with the Judge’s reasoning and decision onthese preliminary issues.

Corresponding authorJoanna Gray can be contacted at: [email protected]

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LEGAL COMMENTARY

Court of Appeal dismisses appealon admissibility of FSA material

as evidence in DirectorsDisqualification Proceedings

Joanna GrayUniversity 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 Statefor Business Enterprise and Regulatory Reform v. Aaron and Others, October 2008.

Design/methodology/approach – The paper outlines the facts surrounding the case andcomments on the ruling.

Findings – Lord Justice Thomas gave the judgment in this appeal, considering the admissible indisqualification proceedings. However, in relation to the Secretary of State’s attempt to rely in evidenceon material in the FOS decision and the FSA final notice LJ Thomas ruled that that the impliedexception to the strict rule of evidence in Hollington v. Hewthorn did not apply so as to allow theiradmission in evidence.

Originality/value – The current market crisis has focused the attention of regulatory investigatorsaround the world on the activities of major UK financial institutions in a number of jurisdictions inwhich 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.

FactsThis appeal was brought by the appellant from a decision of the Chancery Division inApril 2008. An earlier preliminary decision in these proceedings has already beennoted in Journal of Financial Regulation and Compliance, Vol. 16 No. 1, but the factsgiving rise to the application under the Company Directors Disqualification Act 1986 ofwhich 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 businesscarried on by the company had originally been carried on by an IFA partnership whichwas later incorporated to form the company in 2000. In June 2003, FSA had launchedan investigation into the company’s activities which had led it to make certain findingsof breaches of the regulatory regime applicable to the company’s business. Thosebreaches involved the mis-selling of structured capital at risk investment products(SCARPs) to investors. In December 2003, the Financial Ombudsman Service (FOS)



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had made certain findings resulting in a decision from it which went against thecompany and in favour of an investor complainant concerning a direct offer SCARPssale. The company went into administration in 2003. Investor claims (met by theFinancial Services Compensation Scheme) amounted to some £11.9 million.

The secretary of state had brought proceedings under the Company DirectorsDisqualification Act 1986 (CDDA) against three individuals, who were now who theappellants in this appeal, but who had been chairman and chief executive, investmentdirector, and technical director of the company. The secretary of state alleged that theappellants were unfit to be concerned in the management of the company (pursuant toSection 6 CDDA) insofar as they had breached fiduciary duties owed to the company inthat they failed to avoid causing the company to mis-sell SCARPS and that mis-sellingled to the company’s insolvency.

The secretary of state had sought to prove this allegation by relying on a detailedexpert report prepared for use in the disqualification proceedings. This report had beenprepared by an expert (Mr Jeremy Kaye) and the investigations team within theInsolvency Service of (the responsible agency for investigating and bringing companydirectors’ disqualification proceedings), described the rationale for obtaining thisreport as being to “test the findings of the FSA and FOS” and also make any additionalfindings as to aspects of the directors’ conduct which might attract criticism or deserveconsideration.

ActionThe appellants had objected in the original proceedings to use of that report, arguingthat it was inadmissible since it contained matters which went to opinion rather thanfact and pre-empted findings as to their fitness or otherwise to be involved in themanagement of a company when those issues were for the court properly to addressand resolve in trial of the disqualification proceedings. A Deputy Judge of the ChanceryDivision had ruled in June 2007 that the FSA report was admissible as expert evidenceonly to the extent that it addressed “the nature of [the SCARPS] in question and theinvestment risks they pose” and that therefore the secretary of state should file arevised affidavit which would serve as expert evidence on the issue he had identifiedbut would not be any more wide ranging or fuller than was needed for that. Thesecretary of state swore a fresh affidavit, but exhibited to it and referred to within itwere the FSA’s investigation report into the company, and the FSA final notice andFOS decision relating to the company. The appellants challenged that affidavit too andrequested that the secretary of state’s evidence omit all reference to FSA’s opinions orits findings of fact and conclusions expressed in its report or its final enforcementnotice. The Chancery Division Deputy Judge before whom that application came ruledin April 2008 that all the FSA material exhibited in the secretary of state’s affidavitwas admissible in the CDDA proceedings and the appellants now appealed from hisdecision to the Court of Appeal.

DecisionLord Justice Thomas gave the judgment in this appeal and the other two Lord Justicesexpressed themselves to be in agreement with him. He considered the admissibility inevidence in CDDA proceedings of the FSA Report as a separate issue from that of theFSA Final Notice and the decision of the FOS.

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The admissibility of the FSA ReportThe FSA Report contained statements of what the FSA investigators had been told bywitnesses, facts found by the FSA Investigators from the interviews they hadconducted and the enquiries they had made and their conclusions in relation to theconduct 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 outthat the Civil Evidence Act 1995 would normally mean that the statements of whatwitnesses had told the FSA investigators were admissible, despite being hearsay.However, he also pointed out that the findings of fact and conclusions of the FSAinvestigators would normally not be admissible following the rule established in thedecision of Hollington v. Hewthorn [1943] 1 KB 587 as they amounted to findings inother proceedings.

At the core of the dispute about the admissibility of this FSA material was the scopeof an implied exception to the strict rule in Hollington v. Hewthorn that had beendeveloped in subsequent case law. That implied exception made admissible in courtcertain 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 theFSA investigators’ findings of fact and conclusions admissible in these disqualificationproceedings but the appellants contended that the implied exception did not have thateffect and had applied only to hearsay evidence – how dealt with and renderedadmissible by the Civil Evidence Act 1995.

In order to determine this issue Lord Justice Thomas analysed carefully all the caselaw 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 theFSA Report admissible in disqualification proceedings:

[I]t is it is clearly established that in disqualification proceedings whether brought under s.8or under s.7 for an order under s.6 that there is an implied exception to the strict rules ofevidence on hearsay evidence, opinion evidence and the rule in Hollington v Hewthorn. Thiswas developed from the scheme of the Companies Acts on the basis that Parliament musthave intended that a court should have regard to the materials produced under clear statutoryprocedures on which the secretary of state had relied in bringing the proceedings. There wasno real disadvantage to a director. It was no more than prima facie evidence and the directorwas entitled to adduce evidence to contradict the findings and conclusions in the report. Thecourt would reach its own conclusions.

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

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delineated by pleadings. The primary objective of the implied exception is to put beforethe court material obtained under the statutory scheme on which the secretary of staterelied in making his decision and which forms the basis of the case against thedefendant. It enables the defendant to know the case made against him and to put inthe materials on which he relies in response.

In my view, there is good reason to reaffirm not only the principle of the impliedexception and its scope as extending to whatever is contained in the reports and othermaterials obtained under the statutory scheme, but also its eminent good sense inrelation to disqualification proceedings such as this. To abrogate, the exception wouldbe to render of no value a careful investigation, to put the public through the secretaryof 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), itcannot sensibly be argued that the admission of such evidence causes anydisadvantage to the defendant directors. It is plainly relevant evidence which a judgecan and should take into account with all the other evidence in the case, giving it suchweight 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 becondemned on the basis of the opinion of third parties and not of the court determiningthe matter. I cannot accept that submission as having any semblance of reality. A judgeof the Chancery Division will receive all the evidence, including the FSA report and theevidence for the defendants. It is, with respect, absurd to suggest that a judge of theChancery Division who tries this case will not make up his or her own mind but willmeekly follow or be influenced by the views of the FSA investigators. In my view, toexclude the FSA report would be to cause injustice by bringing about further delay andexpense in these proceedings. There is fortunately no need to do so as the scope of theimplied exception is clear. I would therefore uphold the decision of [the ChanceryDivision] on the main issue.

The admissibility of the FOS decision and the FSA final noticeHowever, in relation to the secretary of state’s attempt to rely in evidence on material inthe FOS decision and the FSA final notice, Lord Justice Thomas ruled that that theimplied exception to the strict rule of evidence in Hollington v. Hewthorn did not applyso 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 admissiblein disqualification proceedings; the rationale for relying on the reports and other material fitsinto the statutory scheme, but there is nothing to suggest that the secretary of state can gooutside this scheme. If he could, it would difficult to see what limit there could be to thematerials relied on. There is also good sense in restricting the material relied upon to materialproduced through the statutory scheme for investigation; this is understood by everyone andthe procedure clear. Moreover, a report or other material produced in this way can readily bedistinguished from a decision in an adjudicative process (such as the decision of the FOS orthe 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 Reportprepared under a statutory scheme of investigation, it falls out with the exception tothe strict rule of non-admissibility and so to this extent he did not uphold the decisionof the Chancery Division.

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CommentIt is possible to detect in the tone and tenor of Lord Justice Thomas’ judgment someslight frustration with these elaborate preliminary arguments about the extent towhich the secretary of state’s evidence contained material that related to the company’scompliance with FSA regulation. For as a practical matter, he did not order excision orredaction of any parts of the documents on which secretary of state sought to rely. Hepointed out the fact the costs consequences of so doing and stated that it was quiteusual for a trial judge simply to ignore inadmissible parts of a document in reachinghis conclusions. He makes an interesting more general point which occurred to him as aresult of his consideration of the use made by the Courts of reports of SingaporeGovernment Inspectors in the disqualification proceedings following the collapse ofBarings Bank:

It may be that in a diverse regulatory system within the UK and in a globalised financial andbanking services industry, it is necessary to rely on investigative reports carried out by otherregulators or under statutory authority in other states and that by analogy, such material canbe relied on in disqualification proceedings. That was the effect of the decision in Baringsand, although the point does not arise on the present appeal, I accept that an argument can bemade along those lines and the merits of the argument can be decided when it arises, unlessParliament takes the preferable course of amending the CDDA.

The current market crisis has focused the attention of regulatory investigators aroundthe world on the activities of major UK financial institutions in a number ofjurisdictions in which they were active and, as those overseas regulatory and statutoryinvestigations conclude and report if CDDA disqualification proceedings aresubsequently taken here in relation to the stewardship of those institutions then thisissue may well arise and fall to be resolved directly.

Corresponding authorJoanna Gray can be contacted at: [email protected]

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