Regulating minnows in a sea of sharks

Hong Kong has one of the most open markets in the world.  

Since the early 1990s it has also opened its banking and financial markets, creating one of the most competitive markets for banking in the world. As the rest of China opens, its role will change and regulation must facilitate innovation to keep Hong Kong as relevant as it is today.

Hong Kong has a long history of dealing with the difficult issues of financial regulation. It has had bank runs and failures, as well as public demonstrations about failed products. The market has always been characterized by its diversity of institutions, ranging from the world’s largest banks to small, local banks, pawnbrokers and street-side FX shops.

The large informal sector, the legacy of “gray market” interactions with China and a plethora of outright frauds have always made the financial consumer aware of the caveat emptor presumption. 

High returns come with risk and the people of Hong Kong typically have no more sympathy for people who make imprudent investments than they do for those who make wagers at the ubiquitous Hong Kong Jockey Club betting shops.

This attitude has been so strong that one financial secretary saw fit to comment in 1936 that: “The truth is I think that the Chinese depositor would much rather get a higher rate of interest and lose his entire capital every twenty years or so than get a low rate of interest with security.”1

Hong Kong residents are often refugees from harsh rule and financial oppression. They diversify. It is one of the few jurisdictions in the world where more than half of deposits are held in foreign rather than local currencies. Almost all accounts are by default multi-currency accounts and transaction costs are low.

The currency bulwark of financial stability

However these attitudes are in part also a legacy of what had historically been a volatile financial system. That volatility owed much to the currency regime, with a financial crisis on leaving the silver standard in 1935 and again in 1970s as the Sterling exchange standard broke down and a float with no money supply anchor struggled with international volatility.

Central to the stability of the modern banking system has been the linking of the HKD to the USD since 1983 – colloquially known as the “peg.” The prudential benefits for banks are many. The peg eases cross-currency funding risks that have undermined small country banking systems in a financial crisis. It reduces vulnerability to shifts in capital flows that create currency and interest rate volatility.

Perhaps most importantly it narrows the interest rate risks faced by banks, through the availability of many more USD instruments with which to manage those risks. Meanwhile, reliance on the Federal Reserve removes local policy uncertainty. The very liquid banks are able to place their often large funding surplus in the most liquid global markets at low cost, rather than feeling forced to expand credit risk in local markets where opportunities may be limited.

This integration with the global financial system is high compared to many other markets in the region, which ensures that standards and sophistication of operations within financial institutions matches the best in the world.

The lesson for other markets from Hong Kong is that the most vital “macro-prudential” policies are not the ability to influence markets and credit, but appropriate rules-based and non-discretionary monetary policy.

The evolution of bank regulation

Bank regulation in Hong Kong has evolved from a reliance on self-regulation for authorized banks under the purview, first, of the Exchange Banks Association and the Clearing House, from 1897 to 1981 and, since then, the statutory Hong Kong Association of Banks. Licensing of local banks was not required until 1948, when 143 banks were registered.2

This less regulated period has been viewed unfavourably by commentators,3 who have blamed the crisis and bank runs of 1965, which saw the second largest bank Hang Seng nearly fail before being rescued by HSBC, on lax regulation. Ironically, however, the triggers for these runs were new and stronger regulations.

First, the introduction of a more stringent Building Ordinance in 1964, caused a construction boom, as developers tried to complete work before the ordinance came into effect. Then, banks contracted credit sharply in anticipation of the new liquidity requirements and limits on property holdings of the 1964 Banking Ordinance.4

Following the trauma of the 1965 runs, the government put a moratorium on new entrants to the banking system and limited branch numbers and trading hours, whilst acquiescing on interest rate caps that limited competition. The rate cap was enforced through the Exchange Banks Association. After a vibrant and highly competitive market until the 1960s, the next two decades saw restricted entry, price competition, innovation and market-based consolidation.

With the establishment of the Hong Kong Monetary Authority in 1993, the form of regulation has been more recognizably consistent with international arrangements for prudential regulation by a central bank. However, this also ushered in a wave of deregulation under then-Finance Secretary Donald Tsang that after the Asia financial crisis opened the banking system, especially to competition from foreign banks.

The HKMA was an active participant in and early adopter of each wave of Bank for International Settlement capital rules. However, it has also overlaid those with a preference for simple rules and a degree of prudence under which basic capital and liquidity standards have traditionally been above international norms. 

Bank regulation in Hong Kong today

With the more stringent requirements of Basel 3, there is convergence between local and international requirements for capital and liquidity, although where there are options for conservatism, the HKMA will take them. The recently announced countercyclical capital buffer from 2016 of 0.625 percent common equity tier 1 capital shows the HKMA is implementing the maximum amount under the transition arrangements.

Hong Kong now has just 20 locally incorporated licensed banks and 137 internationally incorporated banks. Licensed branches of foreign banks are not required to hold separate capital in Hong Kong. Requirements for bank licensing are stringent and time consuming, with examples of international applicants not able to license successfully. 

Although capital and liquidity requirements have been largely consistent with international developments, regulators have become very active on other fronts in recent years:

  • A deposit insurance scheme was introduced in 2006, with a coverage limit of HK$500,000 (US$64,103).
  • Regulation of financial products has been significantly extended under the Securities and Futures Commission since the financial crisis, targeting consumer protection, but at the cost of innovation and returns for investors.
  • The HKMA has vigorously advocated “macro-prudential measures,” particularly restrictions on lending to the local property market that have arguably had perverse effects on the supply of and access to housing, as well as contributing to the growth in China lending by Hong Kong banks.
  • A new competition law has been introduced that could in time have a large impact on more concentrated retail segments of the banking industry.

Although bank regulation has become more onerous, on the whole the response of the Hong Kong financial system to the 2008-10 crisis was impressive. No banks failed in Hong Kong. Minor bank runs were contained with the impacted institutions subsequently thriving. Money markets remained liquid. Hong Kong did not impose short-selling bans and managed effectively the large financial flows from the local operations of foreign banks.

This relative success owed much to the aforementioned prudent capital and liquidity requirements and the stable currency regime. Steady improvements in the quality of information disclosure and refinement of the currency board rules since the Asia crisis informed the official response and prevented the panicked reactions of some other markets.

China – caveat emptor

On its face, the Hong Kong banking system has simply evolved and further integrated with the global system. But behind this it has undergone a revolutionary shift in structure. Credit claims that have ultimate risk in China soared from 13 percent as recently as 2009 to 54 percent. Some local banks have been acquired by mainland institutions. The local operations and subsidiary banks of the large China banks have a sharply increasing share of the Hong Kong financial system.

The HKMA, through its clearing operations and work with Chinese authorities opening the market, has embedded Hong Kong at the center of the global market infrastructure for RMB currency financial assets and derivatives.

These changes reflect China’s integration with the global economy, the business decisions of local banks and Hong Kong’s integration with China.  However, they also reflect the paucity of local lending opportunities, particularly as the government has sought to restrict property markets and has subsidized traditional small business lending through loan guarantees. See figure 1

Figure 1

The integration with China has changed risks in the banking system. Arguably the growth of China risk in Hong Kong financial institutions owes much to tighter monetary policy and lending quotas in the rest of China. As much as 78 percent of the lending with ultimate risk in China by Hong Kong financial institutions is supported by China bank guarantees. Much of the activity is seeking credit outside China for companies where it is not available locally. Structures are often designed to work around the limits of mainland capital controls.

Although the HKMA has been vigorous in collecting information about the China activities of the banks that it regulates, it is very reliant on the People’s Bank of China and the China Banking Regulatory Commission to supervise the parent companies of an increasing part of its financial system as well as the China subsidiaries of local banks. Hong Kong is not quarantined from financial risks in the mainland, despite its more mature rules and more open disclosures. 

This presents as much opportunity as risk. China is increasingly opening its financial system and lifting the financial repression that had held back the economy. Indeed in areas of innovation such as online saving products and peer to peer lending, private Chinese companies have wide scope to compete. These companies are introducing financial innovations that leap ahead of other markets.

Hong Kong’s eclipse?

Hong Kong’s banking market has proven resilient. A preference for simple rules, conservative capital requirements, a stable currency regime, solid rule of law and increasing opening to both international and China markets have resulted in the city becoming one of the most attractive jurisdictions for banking activities globally. Hong Kong has resisted protecting its banks from international and China competition, with excellent results.

However, to maintain this position, Hong Kong cannot rest on a storied past. Over the next decade the RMB will become established as a key international currency for both trade and investment. With that, China financial institutions will become more dominant and bring new habits of doing business.

Barriers to entry for smaller financial institutions to Hong Kong are high and increasing. This limits innovation. As more banks are subsidiaries of global giants with global strategies, local innovation and responsiveness is arguably reliant on new entrants.

The regulatory regime for non-bank financial products under the SFC is increasingly onerous and this becomes a bigger constraint as the traditional role of banks is increasingly disintermediated by other financial entities. Competition law may limit both consolidation and innovation. Size, per se, is not the problem and restrictions on consolidation undermine the ability for new entrants to raise capital by reducing exit options.

Getting the balance right as the rest of China opens its markets is challenging. Preserving the writ of the rule of law, even when cross-border activities with China are involved is essential to confidence and stability. Rather than having been eclipsed since 1997, the role of Hong Kong in the China and global financial system has become more indispensable.

However, preserving that role will require the same responsiveness, adaptability and confidence in free markets that has characterized the city so far.