Ladies and Gentlemen:
I have had the privilege of speaking to the Association on two
previous occasions, beginning at its inaugural lunch five years
ago. I am pleased to have the opportunity to do so again,
particularly since the fifth anniversary of the Association marks
another milestone in its presence in Hong Kong. During this time,
the Association has done much to promote the development of the
syndicated loan market in Hong Kong and in the region more
generally. As I noted in my speech to the Association last year,
its work in establishing common standards for documentation has
been particularly commendable.
I want to use this occasion to talk about the current state of
the Hong Kong banking sector and about its prospects. This is
something whose significance extends beyond the interests of those,
such as yourselves, who are directly involved with the industry.
The banking sector plays a vital role in the service-based economy
of Hong Kong, and its profitability is something in which all of us
have a stake. A profitable banking sector is better able to
withstand negative shocks, and this helps to preserve the stability
of the financial system.
The last few years have been challenging times for Hong Kong and
for the banks that operate within it. So far 2003 has shown no
signs of being an exception to this. Indeed, the environment in the
first half of the year has been more than usually turbulent.
Attention at the beginning of the year was focussed on geopolitical
uncertainties, and in particular on the implications of the war in
Iraq for both the global and the local economy. No sooner had
concerns eased on this score - for the time being at least - than
we were confronted with the escalating impact of the SARS
epidemic.
Hong Kong banks are used to dealing with unexpected shocks, but
the threat of disease is something new in modern times. The
immediate need for the banks was to keep their business going and
to protect the health of their customers and staff. Business
continuity plans were therefore activated, including the setting up
of command centres to monitor the situation and the formation of
plans to deal with confirmed or suspected cases of infection among
staff. Critical to this process was the creation of back-up teams
of staff who could man key operations in an emergency from separate
offices or even from home. Face-to-face meetings among staff and
with customers or clients had to be curtailed. Teleconferencing
helped to keep things going, including in the syndicated loan
market.
The need for such arrangements demonstrated that banks must be
able to react quickly and flexibly to unexpected situations. While
they were able to cope with the impact of SARS without major
disruption, a certain amount of improvisation had to take place,
and lessons were learned that should be incorporated into business
continuity plans for the future. But the main point is that the
banks did meet the immediate test posed by SARS, and for that
management and staff deserve our congratulations.
The banks have now been able to wind down their emergency
arrangements, but the effects of SARS on their financial
performance in 2003 will linger for a bit longer, albeit the impact
is now much more muted than at the height of the outbreak.
Despite the underlying economic difficulties, the banks actually
managed to turn in quite a good performance in the first quarter of
the year. Profits of the retail banks in aggregate rose compared
with the same period of 2002, helped by increased fee income,
higher treasury profits, reduced operating costs and a lower bad
debt charge. Towards the end of the quarter, and going into April,
SARS began to have an impact of increasing intensity. The demand
for bank loans, which was already not very buoyant, slumped even
further; credit card spending plummeted as consumers cut back on
shopping and entertainment and tourists disappeared; and branch
traffic dried up, hampering the efforts of the banks to market
their products. Asset quality also began to show initial signs of
deterioration as would be expected given the fall in property
prices and the increased strain put upon the cash flow of the
affected companies and their employees.
From mid-May however the operating environment of the banks
improved as SARS was brought under control. It would be premature
to say that the SARS effect has dissipated entirely. In particular,
the full effects on asset quality may take some time to show
through. But most of the banks that we have talked to are now
saying that the impact of the specific factor of SARS on their
results for 2003 is expected to be relatively mild.
However, the underlying problems in the economy, which SARS
helped to magnify, are still with us. Thus, while the balance
sheets of the banks remain strong, the earnings outlook for 2003
remains uncertain; and the banks continue to face a number of
challenges.
One of these is the state of the property market. The heavy
reliance of the banks on property lending is well known:
residential mortgage lending, in particular, accounts for 35% of
the total domestic loans of the retail banks. Property prices have
fallen sharply since the Asian Crisis, and the effect of SARS was
to produce a further downward spiral. In the three months from
March to May, property prices are estimated to have fallen by 8%.
It is not surprising therefore that the figures for negative equity
reported to the HKMA by the banks have shown a significant increase
from the 83,000 cases (representing $135 billion of loans) recorded
at the end of March.
The negative equity problem affects the banks in various ways.
Most obviously, it poses an increased credit risk since loans in
negative equity have a greater tendency to go into default; and if
they do, the banks will suffer a loss since the loans are no longer
fully covered by the value of collateral. Negative equity also has
a deterrent effect on the demand for new loans since it makes
property a less attractive asset to hold, and by locking in
existing homeowners reduces market turnover. More generally, it has
a pervasively depressing impact on consumer confidence and is thus
a drag on the economy and on loan demand as a whole.
What is encouraging however is that despite the current
difficulties faced by homeowners most of them have made every
effort to continue to service their loans. Although the overall
mortgage delinquency ratio has edged up in recent months, it
remained at a relatively comfortable 1.16% at end-May. The arrears
for loans in negative equity are higher, as you would expect, but
even so the delinquency ratio of around 2.5% is reasonable under
the circumstances.
Nonetheless banks need to keep a watchful eye on the situation,
and adopt a proactive and helpful approach to restructuring
mortgage loans when borrowers start to exhibit signs of financial
distress. What they should be trying to avoid is a repeat of the
problems with credit cards, where many borrowers chose bankruptcy
as a way out of their problems. The dynamics of the two products
are different, but the warning signs are there.
As might have been expected, credit card charge-offs did
increase during the SARS crisis as rising unemployment prompted a
renewed increase in bankruptcy petitions. But the latest news on
this front is somewhat more encouraging. The number of petitions
continued to rise going into the first week of June, but has since
fallen back and the daily average for June as a whole was back to
around the levels that we saw before the SARS outbreak. If this
improvement can be sustained, it would have a positive impact on
profitability in 2003.
Asset quality is an important factor in explaining changes in
profitability across banks and over time. But it is certainly not
the only factor and not necessarily the most important in the long
term. To generalise, changes in bank profitability depend on both
macroeconomic influences and a variety of bank-specific
determinants. The Research Department of the HKMA has recently been
doing some work in this area based on published data of 14 banks
that account for about half the market in Hong Kong. I would like
to share with you some of the preliminary findings of the research
since it casts an interesting light on how the performance of the
industry might evolve over the next few years.
If we look at the performance of the banking industry over the
last decade, the Asian financial crisis clearly marks a watershed.
Between 1992 and 1996 our research indicates that the profitability
of the average bank in our sample, measured by return on assets,
improved by around 0.7 percentage points. It appears that this
performance owed little to the macroeconomic environment of the
time. Rather, it was due to improved performance at the individual
bank level, driven by bank-specific factors such as more efficient
operations and improving asset quality.
In contrast, between 1997 and 2002 the average return on assets
declined by more than 0.7 percentage points. This deterioration was
largely driven by macroeconomic variables, with deflation
contributing most to the worsening profitability. Bank-specific
factors were less significant during this period in explaining both
average performance and variations in performance across banks.
It may seem somewhat obvious to say that the lower profitability
of the banks over the last few years has been largely due to the
poor economic environment. Certainly, as participants in the
syndicated loan market, you will be well aware of the impact of the
current sluggish state of the economy on loan demand and margins.
But the conclusion does have important implications if we look to
the future. If the profitability of the banks has gone down with
the economy, equally it should go up with the economy as it
improves. And this would benefit the banks in general, not just the
select few with a large market share.
In fact, our research indicates that with reasonably
conservative assumptions regarding growth and inflation over the
three years from 2003 to 2005, the profitability for the average
bank in our sample would get back to the average return on assets
over the past ten years by around 2005. Obviously, the improvement
in the economy would need to materialise for this to happen - and I
cannot predict whether it will or not. But at least the banks can
take comfort from the fact that the current difficult operating
environment may to a large extent be due to cyclical factors, which
should eventually reverse.
I would stress that this does not mean that banks should simply
sit back and wait for the rising tide of the economy to lift them
up, or that they should ignore the opportunities that may arise
from merger and acquisition. Bank-specific factors will still
matter in terms of explaining variations in performance across
banks, even if their relative importance was less pronounced after
the Asian crisis.
Among these bank-specific factors, operational efficiency, as
measured by the ratio of non-interest expense to total assets plays
the most significant role in determining profitability, at least
for the banks in our sample. Surprisingly, the effect of credit
quality seems to have diminished over time, perhaps reflecting
improvements in the banks' ability to manage credit risk. But
income diversification has become more important, with banks
increasingly having to develop their fee-generating businesses to
be more profitable. We are seeing this particularly in the move by
a number of banks into wealth management, such as securities, unit
trusts, insurance, pensions and private banking.
A further opportunity for business diversification for the
medium-size banks will come from the ability to branch into
Mainland following the relaxation of the asset size criterion under
CEPA. The eight banks that will benefit from this would, according
to our calculations, have the scope to open a total of as many as
20 branches in the Mainland over the next three years. This would
be a significant addition to the 40 or so branches that banks from
Hong Kong already have on the Mainland. We should certainly not
regard Mainland access as a panacea, and the benefits will take
time to come through. But the important point is that the
medium-size banks now have an alternative avenue to grow their
business outside the Hong Kong market.
Indeed, more generally, banks in Hong Kong will benefit from the
increasing financial and economic integration with the Mainland. In
the syndicated loan market, we can see this in the growing trend
towards Mainland-linked borrowers. One development of this trend is
likely to be the growth of the syndicated loan market in RMB. This
should create opportunities for foreign as well as domestic banks
within the Mainland.
Let me summarise the argument I have been making. Banks of all
shapes and sizes have the opportunity to benefit from the recovery
in the Hong Kong economy when it comes. Some banks will however do
better than others, and our research indicates that a more
efficiently operated and diversified bank will achieve higher
profits. I hope that all the banks sitting here today will be among
those that fall into this category.
Hong Kong Monetary Authority
9 July 2003
