The Hong Kong Banking Industry: to 1997 and Beyond

It is a great honour for me to be here this evening to deliver the keynote address at the Banker of the Year Awards.

The importance of good management

Such awards are of course very gratifying for those who win them. But they also have a wider significance in helping to remind us of the vital part that management plays in ensuring that banks remain profitable and sound. Put another way, bad management is usually the root cause of most banking difficulties, such as problem loans. Of course, banks are also exposed to deterioration in the external political and economic environment which may affect their performance and financial position. But in all but the most extreme cases those banks with good management will pull through. When the going gets tough, poor management is exposed as Hong Kong's experience demonstrated during the early 1980s.

Good management nowadays means not simply concentrating on the short-term problems of attracting deposits and making loans. The business of banking has become more complex and fast-moving and the past is no longer an accurate guide to the future. Management needs to have a positive vision of where they want their bank to be in the medium to long term, and to put in place objectives and action plans to enable that vision to be realized. The larger banks in Hong Kong already have well-developed strategic planning processes, but from my discussions with a number of smaller banks earlier this year, it appears that they are also paying more attention to planning actively for the future.

The challenges facing the banking industry

This whole question of management is highly relevant to the main theme of my speech which is the prospects for the Hong Kong banking industry in the period to 1997 and beyond. The industry is undoubtedly going to face a number of changes over the coming years and the way it emerges from these will depend largely on the abilities of its managers, including those sitting here this evening.

What are these challenges? First of course, there is the political transition that will occur in Hong Kong in less than one year's time. This is a momentous change and it is inevitable that it should arouse much speculation, particularly among the foreign banks which are based in Hong Kong , as to the nature of the post-1997 environment. I will not dwell on this topic at length in this speech, but suffice it to say that the Monetary Authority is confident that the relevant provisions of the Basic Law provide a sound legal foundation for the maintenance of Hong Kong's position as an international financial centre. In particular, the Basic Law makes it clear that:

• the Government of the future Hong Kong Special Administrative Region ("SAR") shall on its own formulate monetary and financial policies
• the HK dollar as the legal tender in Hong Kong shall continue to circulate and shall be freely convertible
• no exchange control policies shall be applied in Hong Kong and the free flow of capital shall be safeguarded
• the Exchange Fund shall be managed and controlled by the Government of the SAR, primarily for regulating the exchange value of the HK dollar

It is worth reiterating these points because I find that despite our best efforts, they are still not fully appreciated outside Hong Kong. However, the legal provisions of the Basic Law will not by themselves ensure that the objectives behind them will be achieved. The words need to be backed up by deeds and both the banking industry and the Monetary Authority have responsibilities in this area. From the banks' point of view they need to ensure that they continue to maintain high standards of capital adequacy, liquidity and prudence in the run-up to 1997 and indeed beyond. It is no exaggeration to say that the eyes of the world will be on Hong Kong during this period, including on its banks, and it is important that no signs of serious weakness emerge which might cast doubts on the stability of the system. Individual banks and their management have a responsibility in this connection which goes beyond their own commercial interests.

The role of the Monetary Authority

For the Monetary Authority's part, we have the responsibilities to maintain monetary and banking stability, to help provide a robust financial infrastructure and to promote the growth, range and efficiency of the financial markets in Hong Kong.

In carrying out our role, both now and in the future, the Monetary Authority is able to rely on the cooperation of the increasing number of other central banking institutions with which we have established both bilateral and multilateral links. These links serve two purposes: first, they enable us to tap into the central banking network of advice and mutual assistance, as demonstrated for example by the series of bilateral repo agreements which we have signed with our regional counterparts. Second, they enable the name and role of the Monetary Authority to become known internationally and thus help to dispel the notions either that there will be a vacuum in monetary control in Hong Kong after 1997, or alternatively that the monetary and supervisory responsibilities will be taken over by the People's Bank of China. Of course, it is inevitable and necessary that there will be close cooperation between the PBoC and the Monetary Authority after 1997, as indeed there is at present. After all, while Hong Kong and China are, and will remain for the next 50 years, two separate monetary systems, they are located next to one another and their economies are closely intertwined. But just as the two monetary systems will remain separate, so will the two monetary authorities, and the PBoC has repeatedly made it clear that it will not take over the role of the Monetary Authority after 1997.

The competitive challenges

The Hong Kong banking industry is also facing challenges of a competitive nature which have nothing to do with 1997. These relate to worldwide changes in the banking environment arising from the forces of globalization, deregulation and technological innovation. These are much-used expressions but they do express a reality which is causing substantial change in the banking sectors in the industrial countries. In particular, the trends towards increased competition and declining margins in traditional banking business help to explain the increased scale of mergers and acquisitions which is now a feature of the main banking centres. Whether or not all such mergers will prove to be successful remains to be seen, but what can be said is that they have a better chance of success in a market such as the United States where a more rigorous approach to cost-cutting is generally pursued after a merger.

So far the trend towards consolidation of the banking industry has left the domestic banking systems of Hong Kong and indeed of the region largely untouched. Where consolidation has occurred it has tended to be in times of crisis with the takeover of ailing banks, or else as a result of special situations. In part, this reflects the family ownership and influence in many banks in the region, including those in Hong Kong, which creates a reluctance to merge. But there are also more fundamental economic influences arising from the growth and development of the region which create an increasing demand for financial services. In other words, while competition for a slice of the cake is increasing, the cake itself is getting bigger. The effect of this in Hong Kong has been that the banks have enjoyed relatively high profit margins over a sustained period. Even in 1995 when the economy slowed down, pre-tax operating profits for the locally incorporated banks as a whole grew by over 20% and the post-tax return on assets was about 1.8%. Although bad debts are on the rise, it looks as if the out-turn for the first half of this year will also be favourable.

The good performance of the local banks in recent years has reduced the economic pressures to merge. Looking ahead, while competition will no doubt increase in Hong Kong, the demand for financial intermediation will also continue to expand. The smaller banks in Hong Kong will continue to have an opportunity to share in this expansion, provided they can establish the right market niche, offer a quality service to their customers and keep a tight rein on costs. In fact, there does not seem to be much of a positive correlation between profitability of the local banks, as measured by return on assets, and their size. Bigger banks are not necessarily more profitable. Although the smaller banks do pay more for their funds, this is outweighed by the higher yield which they earn on their assets. Of course, there is a danger that this higher yield will be earned by pursuing higher risk business. This is why it is important that the smaller banks should keep down their cost-income ratios, which enables them to increase the return on assets without taking on more risk. If they can control costs - which a number appear to be well capable of doing - they should have a profitable and safe future. The key element for success in this task is good management - which brings me back to the theme with which I started my speech.

Despite the favourable prospects for the banking industry, it is possible that some banks may choose to get together to try to achieve economies of scale and in particular to share the costs of new technology. If that were to happen, the Monetary Authority would do its best to facilitate such mergers provided we thought that they were in the best interests of depositors and of the banking system as a whole. In other words, we would want the end-result of the merger to be a stronger institution in terms of financial soundness, management and business prospects. We would certainly not wish to see a bank which was burdened with excessive debt to finance the merger. We do not however see it as the role of the Monetary Authority to take the lead in promoting mergers. We do not have any master-plan for the banking sector in terms of how many local banks there should be and how big. That is something that is best left to the market to decide. Our role in this context is to react rather than initiate.

In talking about the outlook for the banking industry, I have spent most of my time talking about the position of the local banks. I think that that is only natural since they are at the core of the banking system in Hong Kong. However, the contribution of the foreign banks to both the domestic and international banking business of Hong Kong should not be ignored. I would like to take this opportunity to reassure the foreign banks that we want them to go on making this contribution after 1997. Only with the help and presence of the foreign banks can the requirement in the Basic Law be fulfilled that Hong Kong shall remain an international financial centre. The Monetary Authority will continue to play its part by providing a welcoming environment for foreign banks which combines effective supervision with fair and equal treatment for all institutions.

Conclusions

Finally, I noticed in a press article this week that Alan Greenspan once remarked that, "If I have made myself too clear, you must have misunderstood me." Central bankers are of course supposed to be masters of "creative ambiguity" - not least because if nobody can understand what they say, there is less chance of them ever being proved wrong. However, this evening I will depart from normal central banking practice and say clearly and without ambiguity that we in the Monetary Authority are optimistic about the future of the Hong Kong banking industry after 1997 and we hope that all the banks represented here tonight will continue to share in its future success and prosperity.