Circular on Internal Controls and Risk Management Function referencing FSF Report — HKMA — HK

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List of recommendations®
Annex A
II. Strengthened prudential oversight of capital, liquidity and risk
management
Capital requirements
The Basel II capital framework needs timely implementation. Supervisors will assess the impact of the implementation. IIL.1 The Basel II capital framework needs timely implementation. IL2 Supervisors will assess the impact of Basel II implementation on banks’ capital levels and will decide whether additional capital buffers are needed. National 2008 - SUpErvisors National 2008 - SUpETVISOrS, BCBS Supervisors will strengthen the Basel II capital treatment of structured credit and securitisation activities. IL.3 The BCBS will issue proposals in 2008 to raise capital requirements for certain complex structured credit products such as CDOs of asset-backed securities (ABSs).
11.4 The BCBS and I0SCO will issue proposals in 2008 to
introduce additional capital requirements for credit exposures in the banks’ and securities firms’ trading books. I1.5S The BCBS will issue proposals in 2008 to strengthen the capital treatment for banks’ liquidity facilities to offbalance sheet ABCP conduits. BCBS 2008 BCBS, 2008 I0SCO BCBS 2008 Supervisors will continue to update the risk parameters and other provisions of the Basel II framework as needed.
11.6 Supervisors will continue to update the risk parameters
and other provisions of the Basel II framework to ensure that its incentives remain adequate, and will nigorously assess banks’ compliance with the framework. IL.7 Supervisors will assess the cyclicality of the Basel II framework and take additional measures as appropriate. BCBS, 2008 - national Supervisors BCBS 2009 - ® In the third column, the timeline for those recommendations for which work is expected to be continued over time is represented by adding a dash (-) after the date when the implementation is expected to start. 53

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Authorities should ensure that the capital buffers for monoline insurers and financial guarantors are commensurate with their role in the financial system.
11.8 Insurance supervisors should strengthen the regulatory | National 2008 -
and capital framework for monoline insurers in relation to | supervisors, structured credit. Liquidity management IAIS Supervisors will issue for consultation sound practice guidance on the management and supervision of liquidity by July 2008. I1.9 The BCBS will issue for consultation sound practice guidance on the management and supervision of liquidity by July 2008. IL.10 National supervisors should closely check banks’ implementation of the updated guidance as part of their regular supervision. If banks’ implementation of the guidance is inadequate, supervisors will take more prescriptive action to improve practices. I1.11 Supervisors and central banks will examine the scope for additional steps to promote more robust and internationally consistent liquidity approaches for crossborder banks. This will include the scope for more convergence around liquidity supervision as well as central bank liquidity operations. BCBS July 2008 National 2008 - SUpETViSors BCBS, national Supervisors, central banks 2008-09 Supervisory oversight of risk management, including of off-balance sheet entities Supervisors will use Pillar 2 to strengthen banks’ risk management practices, to sharpen banks’ control of tail risks and mitigate the build-up of excessive exposures and risk concentrations. I1.12 National supervisors will use the flexibility within Basel II to ensure that risk management, capital buffers and estimates of potential credit losses are appropriately forward-looking and take account of uncertainties associated with models, valuations and concentration risks and expected vanations through the cycle. National supervisors will report to the BCBS with a view to ensuring a level playing field and the BCBS will share its findings and actions with the FSF.
11.13 Supervisors will strengthen guidance relating to the
management of firm-wide risks, including concentration risks. National SUpEervisors, BCBS 2008-09 BCBS, 2008-09 national Supervisors

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I1.14 Supervisors will strengthen stress testing guidance for BCBS, 2008-09 risk management and capital planning purposes. national Supervisors
11.15 Supervisory guidance will require banks to manage BCBS, 2008-09
off-balance sheet exposures appropriately. national Supervisors I1.16 Supervisors will issue guidance to strengthen risk BCBS, 2008-09 management relating to the securitisation business. national Supervisors I1.17 Supervisors will strengthen their existing guidance on National 2008-09 the management of exposures to leveraged counterparties. Supervisors Relevant regulators should strengthen the requirements for institutional investors’ processes for investment in structured products. I1.18 Regulators of institutional investors should strengthen | National 2009 the requirements or best practices for firms’ processes for | regulators mvestment in structured products. The financial industry should align compensation models with long-term, firmwide profitability. Regulators and supervisors should work with market participants to mitigate the risks arising from inappropriate incentive structures. IL.19 Regulators and supervisors should work with market | National 2008 - participants to mitigate the risks arising from remuneration | regulators, policies. Supervisors Operational infrastructure for OTC derivatives Market participants should act promptly to ensure that the settlement, legal and operational infrastructure underlying OTC derivatives markets is sound.
11.20 Market participants should amend standard credit | Market 2008
denvative trade documentation to provide for cash participants settlement of obligations stemming from a credit event, in accordance with the terms of the cash settlement protocol that has been developed, but not vet incorporated into standard documentation. IL.21 Market participants should automate trade novations Market 2008 and set rigorous standards for the accuracy and timeliness of participants trade data submissions and the timeliness of resolutions of trade matching errors for OTC derivatives.
11.22 The financial industry should develop a longer-term Financial 2008 -
plan for a reliable operational infrastructure supporting OTC industry derivatives. Ln wh

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III. Enhancing transparency and valuation
Risk disclosures by market participants
Financial institutions should strengthen their risk disclosures and supervisors should improve risk disclosure requirements under Pillar 3 of Basel II. I11.1 The FSF strongly encourages financial institutions to make robust risk disclosures using the leading disclosure practices summarised in this report, at the time of their upcoming mid-year 2008 reports. II.2 Going forward, investors, financial industry representatives and auditors should work together to provide risk disclosures that are most relevant to the market conditions at the time of the disclosure.
111.3 The BCBS will issue by 2009 further guidance to
strengthen disclosure requirements under Pillar 3 of Basel IL. Financial Mid-2008 stitutions Financial 2008 - industry representatives, auditors BCBS 2009 Accounting and disclosure standards for off-balance sheet entities
111.4 The IASB should improve the accounting and | IASB
disclosure standards for off-balance sheet vehicles on an accelerated basis and work with other standard setters toward intemational convergence. Valuation 2008-09 International standard setters should enhance accounting, disclosure and audit guidance for valuations. guidance should be enhanced.
111.5 The IASB will strengthen its standards to achieve
better disclosures about valuations, methodologies and the uncertainty associated with valuations. III.6 The IASB will enhance its guidance on valuing financial instruments when markets are no longer active. To this end, it will set up an expert advisory panel in 2008.
111.7 Financial institutions should establish rigorous
valuation processes and make robust valuation disclosures.
Firms’ valuation processes and related supervisory IASB 2008-09 IASB 2008-09 Financial 2008 mstitutions

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II1.8 The BCBS will issue for consultation guidance to BCBS 2008 enhance the supervisory assessment of banks’ valuation processes and reinforce sound practices in 2008. II1.9 The International Auditing and Assurance Standards IAASB, 2008-09 Board (IAASB), major national audit standard setters and major relevant regulators should consider the lessons leamed national during the market turmoil and, where necessary, enhance audit the guidance for audits of valuations of complex or illiquid standard financial products and related disclosures. setters, x relevant regulators Transparency in securitisation processes and markets Securities market regulators should work with market participants to expand information on securitised products and their underlying assets. IHL10 Originators, arrangers, distributors, managers and Originators, 2008 CRAs should strengthen transparency at each stage of the arrangers, securitisation chain, including by enhancing and distributors, standardising information on an initial and ongoing basis managers about the pools of assets underlying structured credit and CRAs products. IT1.11 Onginators and issuers of securitised products should Originators, 2008 be transparent about the underwriting standards for the issuers underlying assets. They should also make available to investors and CRAs the results of their own due diligence. II1.12 Investors, and their asset managers, should obtain Investors 2008 from sponsors and underwriters of structured credit products and their access to better information about the nsk characteristics of asset the credits, including information about the underlying asset managers pools, on an initial and ongoing basis. II1.13 Securities market regulators will work with market Securities 2008-09 participants to study the scope to set up a comprehensive market system for post-trade transparency of the prices and regulators, volumes traded in secondary markets for credit instruments. market participants

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IV. Changes in the role and uses of credit ratings
Quality of the rating process
CRAs should improve the quality of the rating process and manage conflicts of interest in rating structured products. IV.1 10SCO will revise its Code of Conduct Fundamentals 10SCO Mid-2003 for Credit Rating Agencies by mid-2008. 1V.2 CRAs should quickly revise their codes of conduct to CRAs, 2008 - implement the revised I0SCO CRA Code of Conduct authorities Fundamentals. Authorities will monitor, individually or collectively, the implementation of the revised IOSCO Code of Conduct by CRAs, in order to ensure that CRAs quickly translate it into action. 1V.3 CRAs should demonstrate that they have the ability to CRAs 2008 - maintain the quality of their service in the face of rapid expansion of their activities, and allocate adequate resources to both the initial rating and to the rating’s regular review. Differentiated ratings and expanded information on structured products CRAs should differentiate ratings on structured finance from those on bonds, and expand the initial and ongoing information provided on the risk characteristics of structured products. IV.4 CRAs should clearly differentiate, either with a CRAs 2008 - different rating scale or with additional symbols, the ratings used for structured products from those for corporate bonds, subject to appropriate notification and comment. IV.S CRAs should expand the initial and ongoing CRAs 2008 - information that they provide on the risk characteristics of structured products. CRA assessment of underlying data quality CRAs should enhance their review of the quality of the data input and of the due diligence performed on underlying assets by originators, arrangers and issuers involved in structured products. IV.6 CRAs should review the quality of the data input and | CRAs 2008 - the due diligence performed by originators, arrangers and I1SSUETS. 58

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Uses of ratings by investors and regulators Investors should address their over-reliance on ratings. Investor associations should consider developing standards of due diligence and credit analysis for investing in structured products. IV.7 Investors should reconsider how they use credit ratings Investors 2008 - in their investment guidelines and mandates and for risk management and valuation. Ratings should not replace appropriate risk analysis and management on the part of investors. Investors should conduct nsk analysis commensurate with the complexity of the structured product and the materiality of their holding, or refrain from such investments. Authorities will review their use of ratings in the regulatory and supervisory framework. IV.8 Authorities should check that the roles that they have International 2008 - assigned to ratings in regulations and supervisory rules are committees, consistent with the objectives of having investors make national independent judgment of risks and perform their own due authorities diligence, and that they do not induce uncritical reliance on credit ratings as a substitute for that independent evaluation.
V. Strengthening the authorities’ responsiveness to risks
Translating risk analysis into action
Supervisors, regulators and central banks — individually and collectively — will take additional steps to more effectively translate their risk analysis into actions that mitigate those risks. V.1 Supervisors should see that they have the requisite National 2008 - resources and expertise to oversee the risks associated with supervisors financial innovation and to ensure that firms they supervise have the capacity to understand and manage the risks. V.2 Supervisors and regulators should formally National 2008 - communicate to firms’ boards and senior management at an Supervisors early stage their concems about risk exposures and the and regulators quality of risk management and the need for firms to take responsive action. Those supervisors who do not already do so should adopt this practice. 59

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V.3 At the international level, the FSF will give more force to its own risk analysis and recommendations, both directly and through the actions of its members, by initiating and following up action to investigate and mitigate risk. V4 The FSF will establish a mechanism for regular interaction at senior level with private sector participants, including investors and CRAs, for prompting mitigating actions to identified risks and weaknesses. FSF FSF 2008 - 2008 Improving information exchange and cooperation among authorities Authorities’ exchange of information and cooperation in the development of good practices will be improved at national and international levels. V.5 The use of international colleges of supervisors should be expanded so that, by end-2008, a college exists for each of the largest global financial institutions. V.6 Supervisors involved in these colleges should conduct an exercise, by 2009, to draw lessons about good practices. V.7 To quicken supervisory responsiveness to developments that have a common effect across a number of institutions, supervisory exchange of information and coordination in the development of best practice benchmarks should be improved at both national and international levels. V.8 Supervisors and central banks should improve cooperation and the exchange of information including in the assessment of financial stability risks. The exchange of information should be rapid during periods of market strain. V.9 To facilitate central bank mitigation of market liquidity strains, large banks will be required to share their liquidity contingency plans with relevant central banks. Enhancing international bodies’ policy work National supervisors National Supervisors National Supervisors National SUpErvisors, central banks National supervisors, central banks, large banks 2008 2009 2008 - 2008 - 2008 International bodies will enhance the speed, prioritisation and coordination of their policy development work. V.10 Intemational regulatory, supervisory and central bank ' committees will strengthen their priontisation of issues and, for difficult to resolve issues, establish mechanisms for escalating them to a senior decision-making level. As part of this effort, they will establish timetables for required action and action plans for addressing delayed or difficult issues. International committees 2008 -

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V.11 National supervisors will, as part of their regular National 2008 - supervision, take additional steps to check .the supervisors implementation of guidance issued by international committees. V.12 The FSF will encourage joint strategic reviews by FSF 2008 - standard-setting committees to better ensure policy development is coordinated and focused on priorities. V.13 The FSF and IMF will intensify their cooperation on FSF/IMF 2008 - financial stability, with each complementing the other’s role. As part of this, the IMF will report the findings from its monitoring of financial stability risks to FSF meetings, and in tum will seek to incorporate relevant FSF’s conclusions into its own bilateral and multilateral surveillance work.
VI. Robust arrangements for dealing with stress in the financial system
Central bank operations
Central bank operational frameworks should be sufficiently flexible in terms of potential frequency and maturity of operations, available instruments, and the range of counterparties and collateral, to deal with extraordinary situations. VI.1 To meet an increased but uncertain demand for Central banks 2008 reserves, monetary policy operational frameworks should be capable of quickly and flexibly injecting substantial quantities of reserves without running the risk of driving overnight rates substantially below policy targets for significant periods of time. V1.2 Policy frameworks should include the capability to Central banks 2008 conduct frequent operations against a wide range of collateral, over a wide range of maturities and with a wide range of counterparties, which should prove especially useful in dealing with extraordinary situations. V1.3 To deal with stressed situations, central banks should Central banks 2008 consider establishing mechanisms designed for meeting frictional funding needs that are less subject to stigma. V1.4 Central banks should have the capacity to use a variety Central banks 2008 of instruments when illiquidity of institutions or markets threatens financial stability or the efficacy of monetary policy. 61

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V1.5 To deal with problems of liquidity in foreign currency, Central banks 2008-09 central banks should consider establishing standing swap lines among themselves. In addition, central banks should consider allowing in their own liquidity operations the use of collateral across borders and currencies. Arrangements for dealing with weak banks Authorities will clarify and strengthen national and cross-border arrangements for dealing with weak banks. V1.6 Domestically, authorities need to review and, where National 2008-09 needed, strengthen legal powers and clarify the division of supervisors, responsibilities of different national authorities for dealing central banks, with weak and failing banks. governments VL7 Internationally, authorities should accelerate work to National 2008 share information on national arrangements for dealing with authorities, problem banks and catalogue cross-border issues, and then BCBS decide how to address the identified challenges. Authorities will review and, where necessary, strengthen deposit insurance arrangements. V1.8 Authorities should agree a set of international National 2008-09 principles for deposit insurance systems. authorities _VL9 National deposit insurance arrangements should be National 2008-09 reviewed against these agreed international principles, and authorities authorities should strengthen arrangements where needed. Authorities will strengthen cross-border cooperation in crisis management. VI.10 For the largest cross-border financial firms, the most Relevant 2008 directly involved supervisors and central banks should central banks establish a small group to address specific cross-border and national crisis management planning issues. It should hold its first supervisors meeting before end-2008. V1.11 Authorities should share international experiences National 2008-09 and lessons about crisis management. These experiences Supervisors, should be used as the basis to extract some good practices of central banks crisis management that are of wide international relevance. 62