Banking Sector Risks and Challenges
Speeches
16 Jun 2004
Banking Sector Risks and Challenges
Joseph Yam, Chief Executive, Hong Kong Monetary Authority
(Speech at The Hong Kong Institute of Bankers Lunch Talk)
The turnaround
- Thank you for inviting me to talk to you today. It is a
pleasure to be here and I am delighted to see such an enthusiastic
attendance. I was recently looking over past speeches (not, let me
assure you, with the aim of recycling them), and I noted that the
last time I spoke at one of the Institute's lunches was on 24
October 2001. This has prompted me to reflect on how much we have
all been through over the past 32 months - both as a financial
community and in the larger community. When I last spoke to you the
world was just six weeks on from the 9-11 attacks. There was a
strong sense that we were heading for difficult times, with a
worsening global environment, and with deepening deflation,
unemployment, a budget deficit, falling asset prices and a rising
number of negative equity mortgages within Hong Kong. Conditions
were likely to get worse before they got better, I concluded.
- Well, after a period of great difficulty, in which things got
considerably worse than I think any of us had imagined, conditions
are now at last improving. Since around the middle of last year
Hong Kong has been enjoying a strong and broadening recovery. The
economy has now regained much of its dynamism. The key economic
numbers are providing the confirmation. Economic growth has been
impressive. The unemployment rate has been coming down, albeit
slowly. Deflationary pressure has been easing. The external sector
has been active and we are running a substantial current account
surplus. The residential property market, on which the wealth of
many in our community depends, has bottomed out from a falling
trend that had lasted for over five years. Domestic consumption has
been picking up. Of more direct interest to us in the HKMA, the
risks to monetary and banking stability, which had been worrying us
for some time, have receded. The very fast dissipation in the
number of cases of personal bankruptcy and negative equity
mortgages is very welcome indeed.
- The turnaround in the Hong Kong economy and, consequently, the
improvement in the asset quality of banks, were made possible by
the more favourable global economic environment and by measures
taken to strengthen economic ties between Hong Kong and the
Mainland. Indeed, banks in Hong Kong have also benefited directly
from two of these measures. The first is the granting of easier and
greater access to the Mainland banking market under CEPA from 1
January 2004 and the second is the introduction of personal
renminbi business in February. These will in time help to broaden
meaningfully, I am sure, the scope of banking business for banks in
Hong Kong. I should add that there are other initiatives being
developed, with the aim of positioning the banking system of Hong
Kong to take advantage of further financial liberalisation in the
Mainland. I hope they can be agreed, announced and introduced
soon.
Short-term risks
- However, the generally good news in recent months should not
blind us to the problems that remain in our economy or to the risks
that face us. While the economy has been recovering strongly, it
has not been creating as many jobs as we all would like to see. It
is also uncertain to what extent the budget deficit will be
reduced, as government revenues recover along with the economy. To
be sure, the difficult investment environment is not helping us in
our attempt to meet the budgeted investment income for the fiscal
reserves. Disappointments on these fronts may affect market
sentiment in the short term, although the determination and ability
on the part HKSAR government in tackling the remaining, structural
components of these problems should not be in doubt. Furthermore,
there is a risk that our financial markets could over-react to
external developments, notably stronger than expected monetary
tightening in the US, macro-economic adjustments in the Mainland
and sharp increases in oil prices. Although it is unlikely that
these external factors would derail our economy, and so this risk
seems small, under extreme market conditions, short-term volatility
in financial markets could have a bearing on monetary and financial
stability in Hong Kong.
- In contrast, there are also concerns about the effects of
continuing easy monetary conditions within Hong Kong. During the
past few months, economic recovery has resulted in inflows of funds
into the Hong Kong dollar to the extent that the Aggregate Balance
of the banking system has become extraordinarily high (despite some
outflows recently associated with the corrections in the financial
markets). As you know, under the Currency Board system there is not
much that we can do to dampen easy monetary conditions: this is a
question that the Sub-Committee on Currency Board Operations of the
Exchange Fund Advisory Committee has given a great deal of thought
to. If there continue to be capital inflows on the back of
sustained growth and confidence in Hong Kong's prospects, the
current account surplus and continuing talks about a possible
revaluation of the renminbi, the risk of overheating in the economy
and in asset markets will increase. I am not suggesting that this
will happen soon, or making a warning. But banks in particular will
need to keep the situation under close watch and adopt appropriate
risk mitigation measures if the market situation warrants it.
Overheating is, after all, something of an unfamiliar risk after
such a long period of economic difficulty, and we do not wish to be
caught off our guard.
Longer-term risks
- So much for the more immediate risks and potential risks, which
both you as banks and we as supervisor must pay attention to. What
about the longer-term risks facing the banks in Hong Kong? Or, to
put the question in a larger context, what are the longer-term
processes shaping the banking sector that carry risks as well as
opportunities? We in the HKMA have identified a few of these in an
internal exercise that is still ongoing but I would like to share
with you today our preliminary views on five of them. They are:
- structural shift in the banking sector
- China risk
- technology risk
- diversification risk
- changing international standards.
In the remainder of this talk, I shall deal with each of these
areas in turn, focusing more on how we think banks in Hong Kong
should tackle these processes and risks, and less on our
corresponding supervisory responses or strategies, which in any
case are still being developed. My main message is that, while
banks need to focus clearly on the short-term risks I have already
outlined, we should not lose sight of the more fundamental forces
that will shape the landscape of the banking sector in the years to
come. If they do not take these forces into account, individual
banks not only face growing risks, but they could be in danger of
losing their competitiveness.
Structural shift in the banking sector
- First, the structural shift in the banking sector. Over the
past few years the HKMA has been encouraging banks to consider
consolidation as a way of improving competitiveness - technology,
among other factors, has obviously moved the optimum size of a
retail bank towards the larger end. The banking industry has
responded positively: the number of locally incorporated banks has
fallen from 31 three years ago to 24 at present, the result, I am
happy to say, of consolidation and not of abandonment of Hong Kong.
As expected, the various consolidation exercises have produced the
economies of scale intended and, in some cases, immediate financial
benefits for the institutions concerned.
- As consolidation continues, and with the subsidiarisation of
the local operations of a few major foreign retail banks, the
structure of the banking sector will become increasingly polarised.
At one end will be several large banks; at the other end will be a
number of much smaller players. The smaller players will
increasingly face two disadvantages: on the one hand they will find
it difficult to compete; on the other hand, they will find that the
opportunities for consolidation will dwindle over time, as the
number of possible targets for consolidation declines.
- It may not be quite right to classify this structural shift as
purely a long-term risk. In fact, the trend is already there and
the effects of consolidation on the industry as a whole will begin
to be seen very soon. Smaller banks, if they wish to continue to
thrive, should, as a matter of priority, carefully review their
strategic direction. They should, for example, consider whether it
is desirable to grow in size or develop into niche players. Neither
option is an easy one. The opportunities for organic growth in the
local market are limited, while competition for niche operations is
intense.
China risk
- The second important process is the continuing and accelerating
integration of the economies of Hong Kong and Mainland China, which
will be hastened in the years to come by further financial
liberalisation. I have already mentioned the arrangements under
CEPA, in which more medium-sized Hong Kong banks will be able to
access the Mainland market. Let us not overlook movement in the
opposite direction, in which more Mainland banks will seek to enter
the Hong Kong market. On the macro level, as the renminbi moves at
a measured pace towards full convertibility, it seems inevitable
that an increasing proportion of the balance sheet of banks in Hong
Kong would be denominated in that currency. The opportunities
arising from the developments are promising, but they carry risks
as well.
- The growing banking relationship between the Mainland and Hong
Kong will provide important business opportunities for banks in
both places. The question for Hong Kong banks seeking to take
advantage of this process is whether they have the requisite
expertise to properly analyse the business and compliance risks.
Failure in this task will additionally give rise to substantial
operational and reputation risk, particularly for the banks that
have only recently become eligible under CEPA to set up branches on
the Mainland. So far, the medium-sized banks seeking to benefit
under CEPA are doing so primarily to follow their customers into
Mainland China. This simple business model should not pose too much
risk for the banks concerned. But banks that are contemplating more
aggressive expansion plans, such as tapping the local consumer
market, will need at least to be aware of the risks involved and be
in a position to manage them prudently.
- There is a more general and important aspect about this process
of growing banking relationship between the Mainland and Hong Kong.
This process is likely to be characterised by policy shifts that
are more frequent than any other banking environment that we are
familiar with. These policy shifts - mostly in the Mainland rather
than in Hong Kong, and in monetary as well as regulatory policies -
are an inevitable feature of a monetary and financial system that
is going through reform and liberalisation. And in the absence of
deep and sophisticated financial markets in the Mainland to provide
the signals and instruments, the task of risk identification and
management associated with the more frequent than normal policy
shifts is, to put it mildly, a difficult one. An ability to
understand, closely monitor and anticipate monetary and financial
market developments in the Mainland is therefore crucial, for banks
and for us as supervisor. I urge banks to put in the necessary
efforts. Insofar as we are concerned, I think we have developed, in
a limited way, such ability and will, as in the past, share with
the banking community our analyses so that banks can continually
adjust their operations to meet changing market and regulatory
needs.
Technology risk
- The third set of forces arises out of banks' increasing use of,
or rather reliance on, technology. We have seen a spate of fake
bank websites and attempted email scams over the past year: indeed,
the rate of discovery of such cases relevant to Hong Kong has
averaged about 1.4 per month over the past 13 months. It should be
pointed out that we have no report of any customer in Hong Kong
having been taken in by these attempts at fraud. Nevertheless, the
proliferation of fake websites indicates that careful precautions
and constant vigilance are necessary. And a further area of
technology-related crime - ATM skimming fraud - has had its
victims, both in Hong Kong and overseas. Increased security and
heightened customer awareness, we believe, have helped defeat this
form of crime: there have been no new cases in Hong Kong for seven
months. Even so, the elementary, "low-tech" nature of these frauds
demonstrates also that there are many dimensions of the banks'
vulnerability to technology.
- In addition to protection against technology-related crime, the
IT framework of banks also requires business continuity planning
(or BCP). Banks in Hong Kong made great strides in BCP during the
preparations for the onslaught of the Y2K bug. Although the
onslaught never came, we were soon reminded of the importance of
BCP by the 9-11 attack, which alerted us to the need for robustness
in payment, clearing and settlement systems, among other things.
Then the outbreak of SARS last year put the BCP capability of banks
in Hong Kong to a real test. I am pleased to say that the
contingency arrangements of banks - whether of a technical or
personnel nature - performed very well during that difficult time.
Nevertheless, the recurrence of disasters and their unpredictable
nature should always be a feature of BCP and its continuous review.
Indeed, the probability of occurrence of these events seems to have
increased, along with heightened geo-political tension and the
trend of globalisation, not just of trade and markets but also of
terrorism and disease.
- A further area that falls broadly under technology risk comes
from outsourcing. Continuing pressure on profitability will no
doubt result in more banks seeking to outsource their operations to
lower-cost centres outside of Hong Kong. This will in turn give
rise to additional operational risks for banks, including the risks
of service outage and leakage of confidential customer data.
- My main observation from recent experience with handling
technology risk is that bank management should adopt a more
proactive approach towards increasing the overall robustness of the
IT environment, from both the crime prevention and BCP
perspectives. In dealing with these IT-related incidents, we
noticed the concerns sometimes expressed by bank management about
the likelihood of causing unnecessary public panic if these matters
were given publicity. Many preferred to deal with the problems
quietly. The desire to be cautious and to avoid negative publicity
is quite understandable. However, we have found that, far from
causing panic, our insistence on publicity has been helpful in
alerting members of the public of the nature of risks that they are
exposed to as bank customers and how they can protect themselves.
It enhances public education on the issues at hand and promotes the
exercise of a degree of care by bank customers that the situation
demands, not just to protect themselves but also to help in
protecting the integrity of the system. Interestingly, nowadays, we
sometimes receive reports of fake web-sites from members of the
public even before the banks affected become aware of them.
Diversification risk
- The fourth major force shaping the industry is the continued
effort of banks to diversify their income source. This is an
ongoing and inevitable trend given the increasing competition in
the banking market, but it has gathered pace in recent years in
response to the increasing pressure on interest income. The net
interest margin of the retail banks in Hong Kong as a whole has
substantially declined from over 2.19% in 1997 to an annualised
level of 1.67% for the first quarter of 2004. The new sources of
income include most notably the sale of investment and insurance
products.
- The key challenge for banks is simply whether they are capable
of managing the risk arising from these new intermediary
activities. This is particularly so when, encouraged by advanced
technology, the range of products being offered to customers
expands from plain vanilla types to more complex structured
instruments. Furthermore, the awareness of customers about their
consumer rights has increased, thus exposing banks to greater
compliance, legal and reputation risks when venturing into these
new areas of activities. We have seen in recent years an abundance
of cases against the mis-selling of products by banks even in
jurisdictions with more developed financial markets. Banks will
need to properly equip themselves, including substantially
upgrading their compliance and internal audit processes, in order
to rise to this challenge.
International standards
- The fifth set of influences affecting the banking industry is
the number of key international standards that will be introduced
over the next few years. These include regulatory and accounting
standards, and Basle II is the standard most prominent in our
minds. Another example is the implementation of IAS 39. The
adoption of these standards will have profound implications for the
operation of banks in Hong Kong.
- Time is limited, and this is, after all, a luncheon speech, so
I shall not go into detail about these standards. The point to make
here is that, as an international financial centre, we have no
alternative but to implement these standards as fully as we
possibly can and as soon as international agreements have been
reached on them. Many of these standards will be, to put it mildly,
quite onerous. In this connection, I wish to ensure you all that
the HKMA has been adopting a proactive approach in participating in
the relevant international standard setting forums and in
influencing the standard setting processes in the best interests of
Hong Kong. We have also consulted widely in Hong Kong. Insofar as
the banks are concerned, there is a clear need for bank management
to allocate adequate resources to the process of implementation,
which will involve substantial changes to IT systems and compliance
arrangements. For Basle II, for example, banks should not be acting
under the misapprehension that they can simply sub-contract the
implementation processes to third party service vendors, such as
their external auditors. Active involvement of bank management is
crucial in ensuring that most, if not all of these international
standards are properly incorporated into the daily operations of
banks, especially since each bank may face different focuses and
challenges in the process.
Conclusion
- I have drawn attention to five processes that are likely to
have an impact on the banking industry in the future, if they are
not already having an impact. Each of these will, of course, have a
different degree of impact depending on the nature of the
operations of each bank - though I think it is fair to say that no
bank can ignore them. To be sure, facing up to them has important
implications for the limited resources that banks have. In
formulating business strategies for the coming five years, it is
essential for bank management to take into account these processes
in planning their affairs. This goes for the HKMA as well, since
there are important implications for the manner in which we could
perform our supervisory functions effectively. As I mentioned
earlier, we are currently carrying out an internal review on this
subject. As a result of this internal review, there may be a need
for us to make adjustments to our supervisory policies; but there
will be, as usual and as necessary, full consultation with the
industry before we proceed.