Hong Kong Banking: A Situation Report

I am very pleased to be here to address this lunch gathering. I have chosen to use this opportunity to give you a situation report on how we currently see the banking sector in Hong Kong and to talk to you about a number of current policy issues and initiatives which are currently occupying the attention of the Hong Kong Monetary Authority.

Financial disclosure

First however I would like to pay tribute to the important role which the investment analysts play in helping to promote market efficiency and market discipline. In the fast-moving and complex financial markets of today, regulators are increasingly coming to the view that their own supervision needs to be supplemented by adequate public disclosure of the activities and performance of banks and other supervised intermediaries. This enables counterparties to become more aware of those institutions whose performance is substandard or who may be taking undue risks. In this way more discipline is exerted on banks to manage their affairs prudently. Too much discipline can however be a bad thing, particularly if it is applied indiscriminately, and there is always the chance that the market will over-react to "bad news", in the worse case perhaps provoking a bank run. This means that it is important that there should be reliable analysts such as yourselves who can help to interpret published information for the press and the public, and hopefully thereby reduce the chances of extreme market reaction.

In the case of Hong Kong we have moved over the last two years from a situation of very little published information about banks to one where it is fair to say that we are in line with international standards. No doubt as professional analysts you would like to have even more raw material to work with, but I hope that you will agree that the situation is much better than it was. For our part, we felt that it was right that the Monetary Authority should play a more active role in helping to promote increased disclosure by the banks. Of course, such a move can involve risks if the market misinterprets the newly available information or makes invidious comparisons between banks in relation, for example, to the size of inner reserves. I am glad to say however that, with your assistance, no such ill-effects have emerged and the result of the increased disclosure so far seems to have been to improve the market perception of banks in Hong Kong. Among other things, this should make it easier for banks to raise capital and longer-term funds.

I think that it is reasonable to see how the greater disclosure of the last two years settles down before we take any major new initiatives. However, we are intending to recommend that all local banks should include cash flow statements in their 1996 accounts as a number of banks have already done. We are also considering whether to recommend that some quantitative information about the market risk in trading positions in securities and derivatives should be published, though here we are hampered by the fact that there is presently no real international consensus as to how market risk should be measured and disclosed. We are however currently studying this issue.

The performance of the banking sector

I hope therefore that it is now clearer than it was that banks in Hong Kong have a good story to tell. In fact the story in 1995 was rather better than we thought it might be at the start of the year. This is encouraging since it showed the ability of the banks to prosper under less than ideal conditions. I will not go into the 1995 results in any detail since they are now past history. But it is worth recalling that the local banks were able to increase their pre-tax operating profits by over 20% in 1995, producing a return on assets at the post-tax level of more than 1.8%. Underlying this was an increase in net interest margins despite the impact of interest rate deregulation, and improved operating efficiency with the cost income ratio improving from 40% to 38%. At the same time the banks were able to maintain high liquidity and capital ratios - the capital ratio for locally incorporated authorized institutions is over 17%, more than double the agreed international minimum standard.

The results for the first quarter of 1996 and the anecdotal evidence suggest that the banks have made a solid start to this year, although there has been a significant increase in bad debt provisions. While this was from a very low base and might have been expected given the lagged effects of higher interest rates, the credit squeeze in China and the slower growth in Hong Kong, it indicates that the banks will need to pay even closer attention to asset quality, including prompt and accurate loan classification. For its part, the Monetary Authority has been stepping up its monitoring of banks' policies and practices in this area. Apart from continuing our normal on-site examinations of loan books, we are for example now collecting information on credit card receivables and related change-offs. In addition, beginning at end-June of this year, we are asking authorized institutions to report their ten largest individual exposures within the special mention, substandard, doubtful and loss categories on our loan classification return. This will facilitate comparison of the way in which different institutions have classified individual credit exposures and help us to build a confidential register of problem loans. As a further check, we will also be asking selected institutions to commission reports from their external auditors on the effectiveness of their loan clarification systems and reporting. The objective is to ensure that banks are identifying problem loans at an early stage and making adequate provisions against them.

Returning to the performance of the banks so far this year, they have been helped by a decline in funding costs which has widened interest rate differentials: in the first five months of the year, the gap between best lending rate and the one-month time deposit rate has increased to 3.96% compared with 3.66% in the previous five months. Of course, lending margins have been under some pressure, in particular because of the so-called mortgage price war. But the effects of this on the banks' overall net interest margin has so far been quite small - at most, a few basis points on a full year basis - and there are already signs that at least a partial truce in the war has been called. It must also be remembered that while mortgage lending rates have come down, lending volumes have gone up. In the last three months, outstanding mortgage loans have been growing at an annualized rate of almost 20%, which is somewhat above the long-term underlying rate of growth.

The rise in mortgage lending is however a mixed blessing because it adds to the banks' already substantial property exposure. We do accept the argument that mortgage lending has traditionally been a very safe form of lending in Hong Kong. Indeed, the results of a survey which we carried out in September 1994 showed that the percentage of residential mortgage loans which were more than 60 days overdue was only 0.43% of total loans. It is also noteworthy that the fall in property prices of 30% or more from April 1994 to October 1995 did not create any significant problems for lenders. Nevertheless, it cannot be denied that there are risks associated with mortgage lending, in particular the liquidity risk and the concentration risk. Banks need to be cautious about the extent to which they fund long term loans with short term deposits, nor should they be too reliant on income from one particular line of business.

Mortgage Corporation

One way of addressing these concerns is for the regulators to try to limit the growth in property exposure through formal or informal ceilings on property exposure. However, these may be difficult to enforce and can create distortions. A better long-term solution is to consider ways in which the liquidity of banks' mortgage portfolios might be increased and the funding mismatch might be reduced. This is why we are planning to establish a Mortgage Corporation in Hong Kong. The Corporation will help to reduce the banks' liquidity and concentration risks by purchasing mortgage loans from them. It should also help to enhance monetary stability by facilitating the issue of fixed rate mortgages which would insulate borrowers from interest rate volatility. The development of the debt market would also be promoted by the supply of high quality paper issued by the Corporation. The consultation period for the proposal has just ended and the overall reaction from the various interested parties has been highly favourable. This is not to say that there have not been comments and concerns expressed on particular aspects of the proposal, such as the projected shortfall in mortgage funds set out in the consultation paper and the effect of the Corporation on the banks' mortgage business and on the property market.

In general, however, the concept of the Corporation has been widely accepted and we believe that the points of concern can be addressed through a careful definition of the business scope and purchasing policy of the Corporation, a high degree of transparency in its operations, a representative board of directors and sound risk management policies and procedures.

A particular concern of the local banks has been that the Mortgage Corporation could lead to excessive competition and a lowering of profit margins in the mortgage business. This might occur for example if non-bank originators or those using aggressive or predatory pricing were able to off-load mortgages to the Corporation. However, in our discussions with the banks we have made it clear that:

• the Corporation will only buy mortgages from authorized institutions
• it will tend to be a price-taker rather than a price-maker, purchasing mortgages at around the prevailing average market rate
• it will only buy mortgages which comply with specified credit standards
• it will establish limits for individual counterparties from whom it purchases mortgages

Competition

I hope that these points will help to ease the minds of the local banks that the Mortgage Corporation will not erode their franchise. Having said that, the banks will have to accept that increased competition from within and outside the banking sector is a fact of life. I do not think that it is realistic for Hong Kong to turn the clock back and attempt to impose artificial barriers to entry by foreign banks or to discriminate against foreign institutions which are already in Hong Kong. Apart from anything else that would be inconsistent with our obligations as a member of the World Trade Organization. This means that the local banks will have to respond to the competitive challenge by, among other things, tight control of costs, prudent business diversification and a close watch on asset quality. For its part, the Monetary Authority supports increased competition and we have not for example attempted to curb the recent price-cutting in the mortgage market. However, greater competition can become unhealthy if it erodes margins to the point where banks feel obliged to take higher risks in order to restore profitability. Moreover, over-aggressive bidding for deposits may not only squeeze margins but also increase the volatility of the deposit base. That is why we stopped short of full deregulation of time deposits last year and have supported the maintenance of the Interest Rate Rules in respect of current and savings accounts. We recognize that full deregulation of interest rates on deposits is desirable, and no doubt it will come - but not for the time being.

Smart cards

Innovation in products and delivery systems is one aspect of competition that the banks in Hong Kong and the regulators are having to face. In particular, we are in the process of trying to introduce legislation to deal with smart cards or, more specifically, multi-purpose stored value cards. The storing of value on these cards is similar in its economic effect to the taking of deposits or, alternatively, in the Mondex type of scheme, to the issue of bank notes. Both of these activities are regulated in Hong Kong and therefore it seems right that their electronic equivalents should be too. It is our intention therefore that the issue of multi-purpose cards which have a wide and unrestricted usage, and therefore perform the function of money, should be confined to full licence banks. We are mindful however of the need not to stifle innovation and to take account of the convenience of the general public. We are therefore intending that companies which are presently not banks should have the ability to issue stored value cards with a more restricted range of usage through special purpose vehicles. This would cater for those cards which have a core purpose related, for example, to the purpose of tickets for travel purposes, but which might also be used for various ancillary purposes. In considering whether to approve the issue of such cards we would take account, among other things, of the financial standing of the issuer, the use to which the card will be put and the maximum value which can be stored on the card. The draft Banking (Amendment) Bill which includes the provisions related to stored value cards was introduced into Legco on 5 June and is currently going through the legislative process. Given the rapid developments in this area, we hope that it can be passed into law in the near future.

The challenge of new technology

Technological changes such as smart cards, telephone banking and internet banking have the potential to change the bank-customer relationship as we know it today. In particular, they reduce the need for face-to-face contact with the customer and hence the traditional bank network may become less relevant over time. This may allow more scope for niche players with the right technology to enter the market. Already there is one US bank which exists solely on the internet. It also opens up the possibility of increased competition for the banks in at least parts of their business from electronic service providers such as telecom companies and software companies. Traditional banks already have a strong franchise, particularly in Hong Kong, and they are by no means defenceless in the face of these attacks. But they cannot take their position for granted as the pace of technological change and usage accelerates. In particular, banks have to earn the loyalty of their customers through quality of service and by treating them in a fair and transparent manner.

Code of Banking Practice

The record of Hong Kong banks in this respect has been good, but there is always room for improvement, particularly as customer expectations of service quality increase. Satisfying these expectations is a matter for the individual banks concerned, but the Monetary Authority considers that there would be benefits in agreeing industry-wide minimum standards for the way in which banks should conduct business with their personal sector customers. To the extent that such standards help to maintain customer loyalty and public confidence in the banking system, this would be consistent with our supervisory objectives. A working group comprising representatives of the banking industry and chaired by the Monetary Authority is currently preparing a draft Code of Banking Practice which aims to promote good banking practices in areas such as the provision to customers of information about the terms and conditions of banking services and the relevant fees and charges. The Code will also cover the management of the banks' relationship with debt collection agencies which has been a particular area of concern in Hong Kong. It is hoped that the Code can be finalized by the end of this year.

Conclusions

In conclusion, as we have been repeatedly reminded over the last few days, we are now in the final year of the countdown to the change of sovereignty. Although the position regarding the financial system post-1997 is clearly set out in the Basic Law and in the public statements of officials both here and in China, it cannot be assumed that the way ahead to the transition will be entirely smooth. Apart from the political change, the amount of risk in the financial system is increasing as the problems of Barings, Daiwa Bank and now the Sumitomo Corporation have demonstrated. This increases the chances of external shocks affecting the banking system in Hong Kong. The banks must therefore take extra care to ensure that they are sufficiently resilient to cope with the bumps in the road and we regulators must ensure that the supervisory and financial infrastructure provides the necessary support to prudent risk management. I hope that this speech has helped to show that this is a responsibility which the Monetary Authority takes very seriously.