HKMA and SFC issue joint circular following co-ordinated inspections which reveal risky financial arrangements and deficient lending practices

Authors: William Hallatt, Hannah Cassidy and Valerie Tao

On 24 April 2019, the Hong Kong Monetary Authority (HKMA) and the Securities and Futures Commission (SFC) issued a joint circular on their recent co-ordinated inspections of a bank and an SFC licensed corporation (LC) within a Mainland-based group.

The inspections identified two key areas of concern:

• The group had adopted complex structures and opaque financing arrangements, which may have concealed financial risks and made it difficult to conduct rigorous risk assessment.
• There were deficiencies in the lending practices of the bank within the group.

The regulators have indicated that this is not a one-off case and encourage institutions with similar structures and arrangements to conduct a review urgently and take action to mitigate risks.

This is not the first time the HKMA and the SFC have undertaken co-ordinated inspections, but is a relatively new collaborative approach. The SFC has recently stated that, as part of its front-loaded regulation, it will be conducting more joint supervisory exercises with the HKMA.

The regulators have indicated in the circular that they have also been coordinating with Mainland regulators to share information and observations derived from their supervisory work.

What were the regulators’ findings from the co-ordinated inspections?

The following observations from the inspections of the bank and the LC gave rise to the regulators’ concern:

• A subsidiary within the group (which owned the LC) had obtained a credit facility from the bank for general business and working capital purposes. The subsidiary then made a large investment in a private fund, the sole purpose of which was to provide a loan to a special purpose vehicle (SPV) owned by a substantial shareholder of a listed company, against collateral which mainly consisted of the listed company’s shares.
• The loan was used to repay part of a loan of another SPV owned by the substantial shareholder, which had financed projects in an emerging market. This was subject to a margin call arrangement.
• The SFC is of the view that the above arrangement, which was accounted for as an investment in a private fund by the subsidiary, was in substance a margin loan leveraging on the funding support from the bank. In August 2018, the SFC had issued a circular expressing its concerns about arrangements which effectively provide margin financing in the guise of investments.
• The above subsidiary had also provided lending (via a separate subsidiary holding a money lender licence) to other listed companies secured by collateral from major shareholders. Some borrowers had pledged a significant proportion of the listed companies’ total issued shares (up to 70%), which were illiquid and of doubtful quality.
• There were deficiencies in the bank’s lending practices.

What steps should institutions take?

Institutions which adopt structures and financing arrangements similar to the above should undertake a review as soon as possible and take necessary steps to mitigate any financial risks.

The SFC reminds all holding companies or controllers of LCs to prudently manage the overall group financial risks to ensure they have the ability to provide financial support to the LCs and to limit contagion risks to the LCs that may affect financial integrity.

Banks should review their lending practices in respect of credit facilities granted to affiliated companies. This includes:

• ensuring that such credit facilities are granted on an arm’s length basis, and are subject to a prudent credit assessment which should be at least as stringent as that performed on unrelated companies, including evaluating the borrower’s ability to repay and how the facility is intended to be used;
• ensuring that there is an effective post-lending monitoring framework to identify and follow-up on any major adverse developments of a borrower in a timely manner (such as where the borrower engages in high-risk activities or activities that deviate from its normal scope of business), and assessing the risk implications, including whether and how such activities may affect the borrower’s ability to repay.