DFZQ — Interim / Quarterly Report 2019

Sep 20, 2019

Hong Kong Exchanges and Clearing Limited, The Stock Exchange of Hong Kong Limited and Hong Kong Securities Clearing Company Limited take no responsibility for the contents of this announcement, make no representation as to its accuracy or completeness and expressly disclaim any liability whatsoever for any loss howsoever arising from or in reliance upon the whole or any part of the contents of this announcement.

(A joint stock company incorporated in the People’s Republic of China with limited liability under the Chinese corporate name “ 東方證券股份有限公司 ” and carrying on business in Hong Kong as “ 東方證券 ” (in Chinese) and “DFZQ” (in English))

(Stock Code: 03958)

ANNOUNCEMENT ON REPLY TO THE LETTER OF ENQUIRY FROM THE SHANGHAI STOCK EXCHANGE IN RELATION TO POST-VETTING OF THE 2019 INTERIM REPORT OF THE COMPANY

Reference is made to the announcement of 東方證券股份有限公司 (the “ Company ”) dated September 12, 2019 (the “ Announcement ”) in relation to receipt of the Letter of Enquiry on Post-vetting of the 2019 Interim Report of the Company (Shang Zheng Gong Han [2019] No. 2745) (the “ Letter of Enquiry ”) issued by the Shanghai Stock Exchange, which requires that the Company shall disclose the reply to the Letter of Enquiry before September 21, 2019. Unless otherwise defined, capitalised terms used herein shall have the same meanings as those defined in the Announcement. The Company attached great importance to and actively arranged for the reply to the enquires involved in the Letter of Enquiry on an item-to-item basis. The reply to the Letter of Enquiry is hereby announced as follows:

1. IT WAS DISCLOSED IN THE INTERIM REPORT THAT, THE BALANCE OF FINANCIAL ASSETS HELD UNDER RESALE AGREEMENTS AS AT THE END OF THE PERIOD WAS RMB27,279 MILLION, MAINLY REPRESENTING THE COLLATERALIZED STOCK REPURCHASE BUSINESS. IMPAIRMENT LOSS OF FINANCIAL ASSETS HELD UNDER RESALE AGREEMENTS DURING THE PERIOD WAS RMB406 MILLION, COMPARED TO RMB33 MILLION FOR THE LAST CORRESPONDING PERIOD, RECORDING A SUBSTANTIAL INCREASE. PLEASE MAKE ADDITIONAL DISCLOSURE ON THE FOLLOWING:

• (1) progress, duration of the existing projects and risk management of the collateralized stock repurchase business to date.

Reply:

I. Business progress and duration of the existing projects

Since 2017, in line with market changes and upholding the mentality of “scale control, structure adjustment and risk containment”, the Company has been strictly implementing various regulatory requirements relating to the collateralized stock repurchase business (the “ Collateralized Stock Business ”) by taking the initiative in screening business risks and controlling the scale of the Collateralized Stock Business.

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As of the end of June 2019, the Collateralized Stock Business totaled RMB24,053 million, including balance of self-financed financial assets held under resale agreements of RMB22,864 million, representing a decline of approximately one-third as compared to the historical peak amount, and balance of impairment provision of RMB1,239 million, with impairment provision accounting for 5.42%. Duration of the existing projects is as follows: outstanding initial trading amount with remaining maturity of less than 182 days (inclusive) accounted for 88%, outstanding initial trading amount with remaining maturity between 182 days to 365 days (inclusive) accounted for 9% and outstanding initial trading amount with remaining maturity of more than 365 days accounted for 3%.

II. Risk management

The decision-making and authorization system of the Collateralized Stock Business is established and operated in accordance with the structure of the board of directors – business decision-making body – business implementation department – branches and subsidiaries. The board of directors is responsible for determining the upper limit of the total scale of the Collateralized Stock Business. The business decision-making body comprises the Company’s management and the decision-making committee of the Collateralized Stock Business. The Company’s management is responsible for improving the compliance and risk management mechanism of the Collateralized Stock Business and formulating the basic management system thereof. The securities and financial business professional committee of the Company’s sales and wealth management committee is responsible for making decisions on major issues in the business development and supervising and guiding the business operations. The head office of securities finance business is the main business executive department, which is responsible for the overall operating and organizing of the Collateralized Stock Business. According to the regulations and requirements of the Collateralized Stock Business, the business department is responsible for the specific handling of the Collateralized Stock Business under the centralized management of the Company’s headquarters. For lenders who are customers of the collective asset management plans or targeted asset management plans managed by the Company’s asset management subsidiaries, the asset management subsidiaries shall perform corresponding duties according to relevant systems, product contracts, business agreements, etc..

The Company’s risk control measures for the Collateralized Stock Business mainly include access management, underlying securities management, mark to market and post-lending management, default management, etc.. Especially after the new rules on collateralization were issued, our business management mechanism was further optimized to implement the new regulatory rules. Details are as follows:

1 access management

Access management includes access management of the borrower, access management of collateralized projects and control of system parameters. The Company manages the access of the borrower by formulating the access conditions of the borrowers, due diligence of the borrowers, as well as credit rating and qualification examination and approval of the borrowers. Access management of the project is conducted through preliminary evaluation, due

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diligence and graded approval. The Collateralized Stock Business-related system carries out front-end system control on the parameters involved in the access management link, and continuously optimizes such parameters according to regulatory requirements and business development needs. The controlled parameters include, but are not limited to, the trading quota, the lower limit of initial trading amount, the repurchase period, the upper limit of the collateralized ratio of the single underlying securities in the market, the upper limit of the percentage of the single underlying securities in A share capital, the category of the underlying securities, the upper limit of the collateralized ratio of the underlying securities, etc..

2 underlying securities management

The management of the underlying securities includes the management scope of the underlying securities, the management of the collateralized ratio, and the continuous management of the underlying securities. The Company has defined the access conditions for the underlying securities in the system. In terms of collateralized ratio management, it is managed from the three dimensions of upper limit of collateralized ratio, reference collateralized ratio and collateralized ratio management of specific projects. First, the upper limit of the collateralized ratio under each dimension is set from the four dimensions of segment, nature of shares, price-earnings ratio and the collateralized ratio in the whole market, and the “upper limit of the collateralized ratio” of specific securities is determined according to the principle of whichever is lower. Subsequently, the “reference collateralized ratio” is calculated according to the combination of quantitative model and qualitative evaluation. Finally, on the basis of the reference collateralized ratio, the creditworthiness of the borrowers involved in the specific projects, the repurchase period, market dynamics, guarantee credit enhancement and other relevant factors learned from due diligence, is combined with the Company’s business development to determine the collateralized ratio of the specific projects by an increase or decrease on the basis of reference collateralized ratio. The Company will adjust the scope and reference collateralized ratio of the underlying securities according to the requirements of regulatory agencies, market conditions, business development, etc..

3 mark to market and post-lending management

Since the launch of the Collateralized Stock Business, the Company has abided by the relevant regulatory requirements and rules and regulations of the stock pledge business, established a risk control system for the Collateralized Stock Business, and set up special posts to conduct mark to market and post-loan management: to monitor customers whose transactions obligations are yet to be performed and who have underlying securities and transactions to be repurchased, to track the securities with major issues, to focus on contracts and major customers, etc., in particular, systematic monitoring of customer transaction performance and real-time monitoring of default risks of borrowers, mainly including performance guarantee ratio monitoring, maturity monitoring and interest payment monitoring. Through the risk monitoring system, real-time monitoring and risk management are carried out on the implementation of the risk control indicators, so as to timely warn out-of-limit transactions and ensure

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all indicators meet the monitoring requirements. The Company continuously tracks the collateralized underlying securities and the borrowers, understands the relevant factors that may affect the repayment ability of the borrowers and evaluates and tracks such factors, monitors negative public opinions in real time, analyzes and evaluates the transaction risks in time, and takes corresponding measures.

4 default management

When a default occurs in the Collateralized Stock Business, the Company classifies the default according to different types of defaults, and comprehensively considers factors such as the nature of shares, selling restrictions, intention of the borrower, market impact, etc. to select appropriate default management methods, including but not limited to exchange management, judicial management, assignment of creditor’s rights, promotion of customer equity transfer, assisting customers in debt restructuring or asset restructuring, etc..

• (2) specific analysis of the adequacy and rationality of the impairment provision based on the market value decline, default, litigation and impairment test methods of the pledged underlying stocks.

Reply:

I. Impairment test methods

According to the relevant requirements of the Accounting Standards for Enterprises No. 22 – Recognition and Measurement of Financial Instruments issued by the Ministry of Finance and the Guidelines on Impairment of Financial Instruments for Securities Companies issued by the Securities Industry Association of China, the Company shall make provision for impairment of financial assets arising from the Collateralized Stock Business according to the expected credit loss method.

The Company classifies each transaction into three stages by evaluating the changes in credit risk since initial recognition with the classification criteria for the three stages as follows:

First stage: financial instruments with low credit risk or no significant increase in credit risk since initial recognition

Generally, assets classified into the first stage shall meet the following conditions:

• 1 The collateral is sufficient, and the proportion of performance guarantee shall not be lower than the close-out level;

• 2 There is no overdue;

• 3 The financier’s repayment of principal and interest is in good condition.

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Impairment provision for assets in the first stage shall be measured by an amount equivalent to the expected credit loss of such financial instruments within the next 12 months (or within the expected duration if it is less than 12 months).

Second stage: financial instruments of which credit risk has increased significantly since initial recognition, but no credit impairment has occurred

Generally, assets with one of the following conditions shall be classified into second stage:

• 1 The proportion of performance guarantee is lower than the close-out level, but has not exceeded the grace period;

• 2 There is an overdue, but the grace period has not been exceeded;

• 3 Other circumstances that do not fall into the situation where credit risk has not increased significantly or credit impairment has occurred.

Impairment provision for assets in the second stage shall be measured by an amount equivalent to the expected credit loss during the whole life of such financial instruments.

Third stage: Financial instruments that have incurred credit impairment after initial recognition

Generally, assets with one of the following conditions shall be classified into third stage:

• 1 The proportion of performance guarantee is lower than the close-out level, and has exceeded the grace period;

• 2 There is an overdue, and the grace period has been exceeded;

• 3 The financier has major financial difficulties or fraud;

• 4 There are other circumstances that indicate credit impairment has occurred in the transaction.

Impairment provision for assets in the third stage shall be measured by an amount equivalent to the expected credit loss during the whole life of such financial instruments.

For assets in the first and the second stage, the expected loss is calculated according to the probability of default (PD)/loss given default (LGD) model, and evaluation is primarily conducted on the following four aspects:

• 1 Exposure at default (EAD) – Based on the expected changes in exposure, the exposure of a future date is estimated.

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• 2 Probability of default (PD) – Based on the estimation of the possibility of collateralized transaction default within a specific period of time, the Company calculates the historical default rate through migration model based on historical data, and calculates the PD through forward-looking adjustment.

• 3 Loss given default (LGD) – To estimate the losses arising from the default transactions, the main factors considered include the stock market value, the estimated recovery discount coefficient within the remaining duration, etc..

• 4 Forward-looking information – the forward-looking adjustment coefficient is calculated through macroeconomic indicators such as GDP growth rate, PPI year-on-year growth rate, exchange rate changes, CPI year-on-year growth rate, etc..

For assets in the third stage, given that credit impairment has occurred, the probability of default (PD) is 100%. The Company calculates the loss given default (LGD) by comprehensively considering factors such as the creditworthiness of the borrowers, the debt settlement plan, value of collateral and other credit enhancement measures, to measure the expected credit loss.

II. Analysis based on relevant conditions

In the first half of 2019, the Company’s impairment provision of the Collateralized Stock Business increased by RMB406 million, representing a significant growth as compared with RMB33 million in the same period in 2018. The relevant information is stated as follows:

• 1 The Company made a provision of RMB1,064 million at the end of the first half of 2018, of which provision at the beginning of 2018 was RMB1,031 million, with RMB33 million newly added in the first half of 2018. At the beginning of 2018, the Company made a provision for the Collateralized Stock Business because: the Company’s collateralized business started earlier in the industry, and risks were exposed earlier along with changes in the market environment and regulatory environment. At the same time, from the beginning of 2018, the Company has used the expected loss model to calculate the impairment provision. At the beginning of 2018, the Company predicted the overall situation in the future and based on practice of the Collateralized Stock Business, the Company comprehensively considered the decline of market conditions and the exposure of risks in the assessment and calculation of the impairment of the Collateralized Stock Business.

• 2 In the first half of 2019, certain underlying collateralized shares of the Company recorded negative public opinions with either market value falling by a large margin or the credit standing of the financier deteriorating, which led to an increase in the credit risk of certain projects. Based on comprehensive consideration of the creditworthiness of the borrowers, value of collaterals,

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debt settlement plans, risk management progress or other credit enhancement measures, in the first of 2019, the Company newly made impairment provision of RMB406 million for collateralized share projects, among which:

The bankruptcy reorganization plan of the financier of the collateralized stock project Dadongnan ( 大東南 ) (Shenzhen Stock Exchange stock code 002263) has been considered and approved by the Zhuji municipal people’s court of Zhejiang province. According to the plan and the amount of creditor’s rights that the Company can be settled as calculated by the bankruptcy reorganization manager, the Company made impairment provision of RMB176.8854 million in the first half of 2019 according to the difference between the book value and the expected recoverable amount.

In the first half of 2019, the collateralized stock project of Gangtai Holdings ( 剛泰控股 ) (Shanghai Stock Exchange stock code 600687) recorded negative public opinions and the stock price fell sharply. Based on comprehensive consideration of the repayment of the financier, other credit enhancement measures, the bail-out of listed companies and Gangtai Group and the progress of asset restructuring, etc., the Company made impairment provision of RMB179.8376 million in the first half of 2019 according to the difference between the book value and the expected recoverable amount, with the accumulated asset impairment provision of RMB189.2091 million.

Dalian Holdings ( 大連控股 ) (Shanghai Stock Exchange stock code 600747) collateralized stock project was put on record for judicial enforcement in 2017. Based on comprehensive consideration of credit standing of the financier, the value of collateral, the progress of judicial proceedings, and the potential transferee, etc., the Company made impairment provision of RMB69.8158 million in the first half of 2019 according to the difference between the book value and the expected recoverable amount, with the accumulated asset impairment provision of RMB191.2265 million.

As of June 30, 2019, the balance of financial assets held under resale agreements arising from the Collateralized Stock Business reached RMB22,864 million, with a cumulative impairment provision of RMB1,239 million, representing a provision ratio of 5.42%. The classification and percentage of the three stages are as follows:

Unit: RMB100 million

Stage First stage Second stage Third stage Total	Project amount Impairment balance 71.76 0.25 108.64 2.33 48.24 9.81 228.64 12.39	Book value Percentage of provision 71.51 0.35% 106.31 2.14% 38.43 20.34% 216.25 5.42%

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To sum up, based on the nature and characteristics of the Collateralized Stock Business, the Company divides the impairment stages according to the changes in the credit risk of the project, and measures the expected credit loss by estimating the parameters of the project such as exposure at default (EAD), probability of default (PD), loss given default (LGD), etc.. There has been no substantial change in the calculation method and relevant models for the impairment of the Company’s Collateralized Stock Business, which conforms to the provisions of the Accounting Standards for Business Enterprises and the Company’s accounting policies, and is basically consistent with the peers and the impairment provision made according to the expected credit loss model is sufficient and reasonable.

2. IT WAS DISCLOSED IN THE INTERIM REPORT THAT, ORIENT FUTURES CO., LTD, A SUBSIDIARY OF THE COMPANY RECORDED OPERATING INCOME AND NET LOSS OF RMB3,566 MILLION AND RMB68 MILLION, RESPECTIVELY IN THE FIRST HALF OF 2019. PLEASE SPECIFIC THE REASON BEHIND SUCH LOSSES BASED ON THE BUSINESS PROGRESS OF ORIENT FUTURES CO., LTD AND INDICATE THE RISKS REGARDING THE IMPACT OF RELEVANT FACTORS ON THE COMPANY’S FUTURE PERFORMANCE.

Reply:

During the reporting period, Orient Futures Co., Ltd (“ Orient Futures ”), a wholly-owned subsidiary of the Company, realized operating income of RMB3,566 million, mainly due to the income growth of its subsidiary Orient Runhe Capital Management Co., Ltd. (“ Orient Runhe ”).

Orient Runhe is a futures risk management subsidiary filed with the China Futures Association, which focuses on basis trading business to meet customers’ needs for allocation and risk management of spot commodities in different industries and different forms, and actively shifts its layout to bulk commodity investment bank. Orient Runhe is mainly engaged in basis trading, warehouse receipt and other businesses. The specific business models are as follows:

Basis trading business: represents the business of offering quotations and carrying out spot transactions with customers by fixing prices or by means of spot prices and average prices.

Warehouse receipt business: represents the business of providing services to customers by means of commodity spot warehouse receipt swap, warehouse receipt pledge, agreed repurchase, etc.. The above warehouse receipt refers to the standard warehouse receipt with physical goods as the target, the ordinary warehouse receipt issued by the warehousing and logistics enterprise, the negotiable bill of lading and other delivery certificates or goods right certificates, and the company obtained risks and rewards related to the ownership when it gets the relevant control rights.

Income from the abovementioned businesses is recognized when the customer obtains control of the commodity/warehouse receipt, and related costs are carried forward, which has a greater impact on operating income and a smaller impact on profits. During the reporting period, the Company realized income of RMB3,366 million, and cost of RMB3,354 million from bulk commodity trading with relatively lower profit margin.

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As of the end of the reporting period, the total assets of Orient Futures were RMB19,480 million and the net assets were RMB2,971 million. During the reporting period, all businesses of Orient Futures were operating normally. In the first half of 2019, the non-equity assets invested in by the wholly-owned subsidiaries of Orient Futures were degraded in valuation for repayment difficulty of the financier, thus leading to losses on the changes in fair value. In the future, the Company will closely track the changes in the fair value of relevant financial product investments and timely recognize and reflect the impact of relevant changes in fair value on the Company’s performance.

3. DURING THE REPORTING PERIOD, OPERATING INCOME AND PROFIT MARGIN OF THE COMPANY’S INVESTMENT MANAGEMENT BUSINESS RECORDED A YEAR-ON-YEAR DECREASE OF 35.38% AND 2.99 PERCENTAGE POINTS, RESPECTIVELY. PLEASE MAKE ADDITIONAL DISCLOSURE AS TO THE SPECIFIC REASONS BEHIND THE DECLINE IN INCOME FROM INVESTMENT MANAGEMENT BUSINESS BASED ON MARKET CONDITIONS AND COMPARABLE COMPANIES IN THE SAME INDUSTRY.

Reply:

During the reporting period, the Company’s investment management business realized operating income of RMB1,366 million, decreasing by 35.38% as compared to the corresponding period of the previous year, mainly due to the decrease in operating income of Shanghai Orient Securities Asset Management Co., Ltd. (“ Orient Securities Asset Management ”), a wholly-owned subsidiary of the Company. During the reporting period, Orient Securities Asset Management realized operating income of RMB919 million, decreasing by 41.94% as compared to the corresponding period of the previous year.

According to the Operating Data of Securities Companies for the First Half of 2019 disclosed on the official website of the Securities Association of China, the net income from asset management business of securities companies in the first half of 2019 was RMB12,733 million, down by 8.32% from RMB13,888 million in the same period last year. During the reporting period, Orient Securities Asset Management realized operating income of RMB919 million, down by RMB664 million from the same period of last year. The main reason behind the greater margin in decline than that in the industry was the decrease in additional management fees and performance compensation recognized. In order to better implement the concept of “putting the interests of customers first”, Orient Securities Asset Management has made arrangements for provision of additional management fees upon maturity of long-term closed products and provision of performance compensation upon redemption by customers and dividends distribution. In the first half of 2018, RMB139 million of additional management fees were provided upon maturity of the three-year Dongfanghong Ruiyuan ( 東方紅睿元 ), and some targeted products reached the performance compensation provision cycle, resulting in a relatively large base for the same period last year.

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4. IT WAS DISCLOSED IN THE INTERIM REPORT THAT, CERTAIN RISK CONTROL INDICATORS OF THE COMPANY RECORDED CHANGES AS AT THE END OF THE REPORTING PERIOD. IN PARTICULAR, LIQUIDITY COVERAGE RATIO DECREASED FROM 290% TO 197% AND CAPITAL GEARING RATIO DECREASED FROM 16.31% TO 14.17%. PLEASE ANALYZE THE REASONS BEHIND SUCH CHANGES ON AN ITEM-TO-ITEM BASIS BASED ON BUSINESS CONDITION AND COUNTERMEASURES PROPOSED TO BE ADOPTED.

Reply:

In strict accordance with the requirements of the Measures for the Administration of Risk Control Indicators of Securities Companies and its supporting rules, the Company measures, monitors, evaluates and analyzes net capital and related risk control indicators. Throughout the reporting period, the Company’s major risk control indicators met regulatory requirements, and the fluctuations of individual indicators were reasonable in the course of business development.

Liquidity coverage ratio decreased from 290% to 197%, mainly due to the following two reasons:

• 1 High-quality liquid assets decreased by RMB1,842 million, or 3.62%, mainly due to the increase in collateralized bond financing business surpassing the increase in bonds held during the reporting period, resulting in the decrease in high-quality liquid assets. At the same time, for the purpose of investment income, the Company replaced some assets with high conversion rate with currency funds and ETF constituent stocks with relatively low conversion rate.

• 2 The next-30-day net cash outflow increased by RMB7,340 million, or 41.84%, mainly due to: first, the Company repaid RMB4,000 million of short-term financing bonds in July 2019, the principal and interest of which fell into “subordinated debts and other debts to be repaid within 30 days” at the end of the reporting period; second, during the reporting period, the Company steadily promoted the innovation and transformation of FICC business, and the scale of commodity leasing, commodity options and other businesses increased, resulting in a total increase of RMB4,855 million in financial liabilities held for trading and derivative financial liabilities.

To sum up, the fluctuation of the Company’s liquidity coverage ratio indicator during the reporting period was due to the Company’s daily business development and the structural adjustment of assets and liabilities, which were reasonable. The Company has always attached great importance to liquidity risk management and is committed to improving the level of refined management of indicators. In the future, the Company will continue to predict and measure various liquidity indicators, including liquidity coverage ratio, to ensure that the indicators meet regulatory requirements in the long term and maintain a certain margin of safety.

The Company’s capital leverage ratio was 14.17%, down by 2.14 percentage points from 16.31% at the end of last year. During the reporting period, the Company’s core net capital remained relatively stable, while the total on-and off-balance-sheet assets increased by RMB27,736 million, representing an increase of 14.63%, which was the main reason behind the change of such indicator.

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During the reporting period, the main items of changes in the Company’s total on-and off-balance-sheet assets include: first, the balance of the Company’s on-balance-sheet assets (excluding customer funds) increased by RMB16,488 million, of which other debt investments increased by RMB5,336 million, financial assets held for trading increased by RMB5,012 million, monetary funds (excluding customer funds) increased by RMB3,289 million, and funds lent increased by RMB1,309 million; second, the Company’s off-balance sheet derivatives increased by RMB6,062 million, mainly due to the Company’s steady promotion of innovation and transformation of FICC business during the reporting period, and the continuous expansion of interest rate swaps, commodity options and other businesses.

The Company will continue to adhere to sound financial policies, strengthen risk control, actively promote the standard development of various business, and further take the following measures to strive to improve the safety margin of the Company’s capital leverage ratio indicator: first, to strengthen asset and liability management, continuously optimize the asset and liability structure, prudently control the level of financial leverage, and enhance the profitability of core assets; second, to evaluate the matching between the risk capital consumption and profits of various off-balance sheet derivatives businesses to further optimize the business structure; third, to prudently control the scale of long-term asset investment, strengthen pre-investment research and analysis, so as to reduce the consumption of core net capital.

By order of the Board of Directors PAN Xinjun Chairman

Shanghai, PRC September 20, 2019

As at the date of this announcement, the Board of Directors comprises Mr. PAN Xinjun and Mr. JIN Wenzhong as executive Directors; Mr. LIU Wei, Mr. WU Junhao, Mr. CHEN Bin, Mr. LI Xiang, Ms. XIA Jinghan, Mr. XU Jianguo and Mr. DU Weihua as non-executive Directors; and Mr. XU Guoxiang, Mr. TAO Xiuming, Mr. WEI Anning, Mr. XU Zhiming and Mr. JIN Qinglu as independent non-executive Directors.

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