Banks play an important part in keeping the economy going in difficult times.
As credit concerns in the interbank market spread to the retail level, borrowers are feeling the strain. It is understandable that the banks may wish to tighten credit: the global financial crisis is affecting them in many ways. First, there is the inevitable negative impact on asset quality as the prices of financial products fall sharply. They may hold some of these assets and, under current accounting rules, they may then need to price them at significantly written-down values or make provisions or even write them off. Their customers may also hold some, and this may affect their ability to service their bank loans. Secondly, some banks are buying back Lehman Minibonds that they had sold to investors and may have to compensate those investors if mis-selling is shown to have been involved. Thirdly, the bank run in late September threw doubt on the stability of customers’ deposits as a funding source. Fourthly, the slowing economy will inevitably erode the ability of borrowers to service bank loans.
In times of financial crisis, it is common for financial-intermediation channels to become blocked and for the financial system to falter in servicing the financing needs of the economy. The current financial crisis is no exception. In Hong Kong the equity market as a channel of financial intermediation has dried up under the influence of sharp declines in secondary market prices, and investors have simply lost interest in initial public offerings. Activity in the debt market, which in any case has always been relatively quiet, has sunk to extremely low levels, as investors become sceptical about credit risks for debt instruments where, for some products, liquidity can evaporate quickly and the price-discovery mechanism fail, leaving investors wondering whether what they hold is still worth anything. It is therefore predominantly left to the banking system to play the important role of financial intermediation, channelling funds taken as deposits to borrowers.
It is in difficult times like these that the banks are particularly called upon to bear the important responsibility to keep the economy going. I am sure bankers in Hong Kong are aware of their heavy responsibility and the implications of their actions on the well-being of Hong Kong. We in the HKMA will try and help as much as possible. The temporary 100% deposit-protection arrangement should help to stabilise their deposit bases as a source of funding over the next two years. There are also temporary arrangements, including the two refinements introduced today, for the provision of term liquidity to individual banks, either through the Discount Window, or outside it if there is adequate collateral of acceptable quality. The interest rate for the provision of such liquidity has also been lowered by one full percentage point through amending the formula for determining the Discount Rate. We also stand ready to provide more liquidity to the banking system as a whole, through market operations within the Convertibility Zone, and by increasing the Aggregate Balance (through purchasing US dollars in accordance with the Currency Board rules), as long as exchange-rate stability is not affected. Put simply, the liquidity is there and in large amounts. We have done our part and we are prepared to do more, if circumstances require. It is time for the banks to deliver as well. Their actions are important for the continuing functioning of the economy through difficult times. We all are in the same boat and now is not the time to rock it.
It is of course for the banks to manage credit risks and price credit flexibly in the light of changing conditions and changing risks. As banking supervisor we expect no less. But the real possibility that banks tightening credit will adversely affect economic prospects and in turn their own asset quality, and that this process might feed on itself creating a downward spiral, cannot be lightly dismissed.
And for those watching closely the performance of the banking system, we enter this difficult period from a position of strength. There is room to absorb damage, wherever it comes from and however it is manifested in the system. One must expect the asset quality of the banks to deteriorate somewhat from the current, very robust starting point, with the ratio of classified loans being less than 1%, remembering that the ratio rose to over 10% after the Asian financial crisis.
Joseph Yam
6 November 2008
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