On February 21, 2024, the Financial Supervisory Service (the “FSS”) announced its “2024 FSS Audit Operation Plan” (the “Audit Plan”). Considering the recent reorganization of the FSS’s audit function, and the FSS’s focus on further strengthening its audit capabilities, it will be critical for banks and financial holding companies to thoroughly review their business operations based on the details of the Audit Plan in preparation of future FSS audits.
Through this year’s Audit Plan, the FSS announced that it will (i) eradicate bad management behaviors that pursue short-term results while shifting the risk towards consumers and financial crimes that undermine consumers’ livelihoods, (ii) proactively inspect risk management practices across the financial sector in preparation of potential losses that may arise from investments in risky assets, and (iii) penalize unsound sales practices that deceive consumers through various audits upon the sales organizations of financial institutions.
To this end, the FSS plans to establish an inspection system that will allow coordination amongst its audit teams and will give flexibility to concentrate its resources on important matters, while reducing financial companies’ audit burden. As such, it is expected that the financial authorities will (i) discourage financial companies from putting too much emphasis on performance, (ii) continue their policing of financial crimes, and (iii) strengthen audit activities in order to improve financial consumer protection.
Based on the FSS’s key audit topics for 2024, we expect the FSS to focus on the following issues with respect to the banking sector:
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The FSS will focus on inspecting the adequacy of internal controls and illegal activities such as mis-selling in relation to the sale of financial products such as Equity Linked Securities (“ELS”) and Equity Linked Trusts (“ELT”) that use the Hong Kong H Index as the underlying asset. Post-audit measures (e.g., imposing sanctions or arranging voluntary compensation to investors) resulting from the FSS’s audit of banks and securities firms regarding such ELS products are underway, and the FSS will likely step up its audit of illegal activities related to the sale of other financial products. Therefore, banks will need to review their businesses regarding the sale of non-depository products and thoroughly prepare for future regulatory audits based on their experience in dealing with regulatory audits and sanctions involving the mis-selling of derivative-linked funds (“DLF”) and private placement funds. |
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The FSS plans to inspect the risk management practices of financial institutions regarding their investment decisions on high-risk assets seeking short-term gains such as real estate project financing deals, and encourage financial institutions to make adequate provisions in their accounting books to ensure they can absorb the loss once it materializes. In case there are any signs of systemic risks arising, the FSS will utilize its audit teams to promptly and preemptively respond to such risks. As a countercyclical capital buffer system and other prudential regulations for banks will gradually be introduced, proper loan loss provisioning, stress testing, and additional capital accumulation will likely be key audit points. Therefore, financial institutions will need to pay particular care to risk management while proactively assessing factors such as household debt and real estate market downturn, which may signal systemic risk. |
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The FSS is also interested in reviewing the target profit margin for loans, the criteria for calculating margins and charging fees, whether financial institutions are complying with their obligation to provide customers the right to request interest rate reductions or to withdraw from loan contracts, as well as reviewing credit applications and managing (including extending and recovering) existing credit provided to Small and Medium Enterprises (“SMEs”) and sole proprietorships, and the adequacy of writing off and selling non-performing loans. As such, the FSS will be focusing on financial consumer protection when reviewing the adequacy of a bank’s overall credit business throughout its entire banking organization. Banks will accordingly need to thoroughly check their compliance with the Financial Consumer Protection Act as well as their credit business practices regarding SMEs, sole proprietorships and low-to-middle income customers, which are particularly relevant to providing financial stability and supporting the economy as a whole. |
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The FSS will check whether financial institutions are adequately reflecting the “Best Practices on Banking Governance.” On July 7, 2023, the FSS, together with several research institutes and banks, launched the “Task Force for Establishing Best Practices on Banking Governance,” and on December 2023, it proposed best practices (i.e., core principles of the best practices for governance) on (i) establishing a support network for outside directors, (ii) improving CEO appointment procedures and management succession procedures, (iii) evaluating the collective suitability and independence of the board of directors, and (iv) enhancing the performance evaluation system for the board of directors and outside directors. The FSS is expected to check whether banks are complying with these core principles, and if not, whether reasonable alternatives are in place in light of each bank’s business strategy and organizational size. Therefore, banks will need to review the operation of their internal committees, including the board of directors and executive nomination committee, and implement measures to improve corporate governance. |
Recent scandals involving large-scale embezzlement cases at banks have led to calls for stricter regulations on banks. In particular, with ongoing audits regarding ELS and ELT products that use the Hong Kong H Index as the underlying asset, the banking industry will need to prepare not only for future audits and sanctions, but also for civil disputes and potential voluntary compensation to customers for the losses incurred with respect to such ELS and ELT products. In addition, once the Corporate Governance Act, which will require financial institutions to manage their internal control systems, comes into effect on July 3, 2024, the banking sector will be the first to be subject to submitting a Responsibilities Map for senior executive positions.
In addition, on July 5, 2023, the financial authorities announced the “Measures to Improve the Management and Operating Practices of Banks and the Banking System” to allow new players to enter the banking sector and to improve regulations on local banks and the branch offices of overseas banks. These measures were introduced to increase competition in the banking sector where the status quo remains relatively unchanged compared to other industries.
The business and regulatory landscape of the banking sector is experiencing an unprecedented and rapid change, and banks will need to thoroughly prepare for these changes by identifying the key audit issues of the FSS in order to mitigate potential sanctions and legal risks. In particular, the FSS announced that it will be conducting seven regular and 80 non-periodic audits for the banking sector this year so it would be important for banks, financial holding companies and branches of overseas banks to review their internal business systems and policies in preparation for such audits.
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