Guarantee of repayment of deposits in Hong Kong

inSight

16 Oct 2008

Guarantee of repayment of deposits in Hong Kong

Prevention is better than cure.

Over the past year or so of financial crisis in the developed economies, I have on many occasions drawn the attention of all concerned to the robustness of the banking system of Hong Kong. The purpose of doing so was to minimise any possible adverse effects of the continuing financial crisis in the United States and Europe, which was seriously threatening banking stability there, on confidence in the banking system of Hong Kong. My comments were based on indisputable facts about our banking system. The asset quality of the banking system is very good, with the aggregate classified-loan ratio of the retail banks at a very low level of less than 1%. This can be compared with the corresponding figures of over 10% in September 1999 when the economy was severely affected by the Asian financial crisis of 1997-98 and the subsequent bursting of the housing bubble, and 2.5% before the Asian financial crisis. The aggregate capital adequacy ratio of the locally incorporated banks, currently at around 14%, is way above the minimum of 8% prescribed in law, indicating a very comfortable capital cushion to cope with severely adverse circumstances. The aggregate liquidity ratio, at over 40%, is also way above the statutory minimum of 25%.

A few events, however, have clouded the overall picture despite these facts, threatening to erode the community's confidence in the banking system of Hong Kong. First it was the collapse of Lehman Brothers, the fourth largest investment bank on Wall Street, hurting investors in Hong Kong who had purchased financial products relating to Lehman through the banking system. Second, at a time when public sentiment was aroused by allegations of mis-selling of financial products related to Lehman Brothers by banks, malicious rumours about the financial position of a bank led to a run. Although the run was stopped by decisive action by all concerned, doubts had been raised on the safety of deposits in the banking system, threatening to affect individual banks indiscriminately, notwithstanding their healthy financial positions. Third, and this was the most threatening of all, the banking systems in many developed markets and therefore the global financial system were described by authoritative sources as on the brink of collapse. The risk of serious contagion, working through fear and highly correlated global financial markets, was clearly there and increasing rapidly, possibly leading to a corresponding breakdown of confidence in the local banking system. Meanwhile, fourth, the potent dynamics of international finance pointed to the distinct possibility of cross-border movements of deposits seeking a safe haven where there are specific guarantees of safety, and free and open financial systems without such guarantees being subject to further destabilising, external influences. Robust facts and figures might not be enough to sustain confidence in a situation of fear and uncertainty. Clearly, there was a need for a confidence booster for depositors to put their minds at ease over the safety of their deposits well before doubts developed and became widespread.

The banking system is robust. We know it through facts and figures, and our supervisory activities. The probability of a bank failure in Hong Kong is thus very low. In the unlikely event that there is a bank failure in Hong Kong, for whatever reasons, the probability that the bank will be insolvent, in other words, that the assets of the bank on liquidation will be inadequate to cover its liabilities, is also low. This means that, if the Government guarantees the repayment of all deposits in Hong Kong in the event of a bank failure through the use of the Exchange Fund, the contingent liability for the Fund, in the form of the shortfall, if any, of assets over deposit liabilities of the failed bank, would be small.

The guarantee of the repayment of all deposits in Hong Kong is a temporary measure applied at a delicate time when confidence in the banking system is threatened by what is described as the worst global financial crisis in a century. This type of blanket guarantee for depositors may, however, introduce distortions to the banking system. For example, it may affect the incentives for prudent management of risks by banks, the competitive environment among banks and the need for depositors to exercise due diligence. This, in turn, may lead to considerable moral hazard. Additional supervisory attention will therefore need to be paid to these various aspects, even though they are of a temporary nature.

Joseph Yam
16 October 2008

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