Interest rate liberalisation has been good for both depositors and borrowers. Publishing the composite interest rate is intended to provide a reference for the banks and their customers.
One of the early reforms we introduced after the establishment of the HKMA in 1993 was the phased programme for liberalising interest rates in Hong Kong. There were two important considerations behind the decision, which was made in 1994. The first was the need for Hong Kong dollar interest rates to be as flexible as possible to accommodate and adjust efficiently to short-term flows of funds into and out of Hong Kong under a fixed exchange rate system. The second was to introduce greater competition into the banking system of Hong Kong. We believed that this would make financial intermediation through this important channel more effective, resulting in higher returns for depositors and a lower cost of funds for borrowers.
We proceeded with great caution and after extensive consultation. We were acutely aware of the possibility that greater competition in the banking sector, while in the public interest, might create undue pressure on the banks' management to make profits for shareholders by taking more risks than necessary, to the extent of undermining the interests of their depositors and the stability of the banking system. Financial liberalisation always involves risks and a pre-requisite for proceeding is to prudently manage those risks. The whole process of interest rate liberalisation took seven years, starting in October 1994 with the deregulation of interest rates for time deposits of longer-term maturity and ending in July 2001 with the deregulation of interest rates for savings and current account deposits. But we did have to pause for a while in between, when the resumption of sovereignty approached, followed by the Asian financial crisis.
As I have mentioned on several occasions, including my briefing to the Legislative Council Financial Affairs Panel on 7 November, both depositors and borrowers benefited significantly from the removal of the Interest Rate Rules of the Hong Kong Association of Banks. The greater competition arising from interest rate liberalisation led to a narrowing of the net interest margin of banks from over 2% to around 1.6%, suggesting that depositors are getting more for their deposits and borrowers are paying less for their bank loans. The borrowers seemed to have benefited more, as banks were more ready to compete for business on the lending side. This has been most obvious in mortgage interest rates. From being priced at around 1.5% above the best lending rate before the interest rate liberalisation, mortgage rates have fallen to around 2.5% below the best lending rate – a fall of four percentage points. For a typical family with a mortgage to service and some money in a savings account, instead of having to pay nearly seven percentage points more for their mortgage than they were receiving from their savings deposits before the interest rate liberalisation, the gap now is only about three percentage points.
Throughout the seven-year period leading up to interest rate liberalisation, and with freely determined interest rates since then, the HKMA as the banking supervisor has been very alert to the risk profile of banks. We are satisfied that risk taking has not been excessive, and suitable risk-management measures are in place when risks are being taken, recognising of course that banking is a risk business. Concurrently, we have been progressively moving towards risk-based supervision, a practice that will be strengthened with the planned introduction of Basel II, scheduled for the beginning of 2007.
With the banks determining their own deposit and lending rates freely, it is possible for there to be different levels of deposit and lending rates in the market. This is no bad thing, as long as the actual deposit and lending rates are transparently advertised. Indeed, depositors and borrowers are free to choose the bank they wish to deal with, and they are probably sophisticated enough to take care of themselves. But some have found this a little confusing, and this is not helped by the fact that the mortgage rate is actually below the best lending rate. The confusion can of course be addressed either by giving the best lending rate a more appropriate name or, as we suggested, by using another reference interest rate. There is the base rate that we publish, on the basis of which we provide liquidity to banks through the Discount Window, which is quite stable. There is of course the inter-bank offered rate (HIBOR) for funds of different maturity, which can be quite volatile. And there is our suggestion of a composite rate reflecting the average cost of funds of the banks in Hong Kong. We recognise that funding structures differ among banks, but that did not stop them from using the same best lending rate for a long time. In a free market it is up to the banks to determine their own interest rates, as long as the interest rates are clearly conveyed to customers.
Even though the banks have decided not to adopt the composite rate, we are publishing it as a reference for the banks as well as their customers. Customers can of course always request their banks to price their lending by reference to the composite rate.
Joseph Yam
8 December 2005
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