Chapter 14 & 15

The Banking Industry & Banking Regulation Crisis and Response

Panic of 1965

In 1964, there was a collapse in the property market. In January 1965, the Banking Commissioner closed Ming Tak

bank which suffered losses in property investment. Two weeks later there was a run on deposits at Canton Trust

which also had property holdings. Canton Trust suspended business on February 8.

On February 9, there were runs on deposits at many native banks including Wing Lung, Dao Heng, and the strongest of the native banks Hang Seng.

On April 9, Chinese newspapers published rumours that the head of Hang Seng was being interviewed by the police.

By the end of the day, depositors had withdrawn half of the savings and checking deposits at Hang Seng.

On April 10, Hongkong Bank took over Hang Seng.

Objectives

Learn the basic attributes of the Hong Kong banking market.

Understand the fundamentals of the regulatory regime.

Origins of Today’s Banking Industry1845: Oriental Banking Corporation was the first

British bank to open in Hong Kong.

1865: First bank incorporated in Hong Kong was Hongkong Bank (now HSBC).

1865-1948 Colonial laws regulated the note issuing banks,

Hongkong Bank, Chartered Bank of India, China, and Australia (now Standard Chartered), and Mercantile Bank (which merged into HSBC in 1950’s).

Otherwise, only minimal restrictions on banking until 1965 when crises at a number of banks culminated with HSBC taking over Hang Seng bank.

Historical Origins

Origins of current licensed banks can be divided into 4 categories

1. Modern Local Banks: Colonial banks and Chinese banks dating from pre-war period. (HSBC, Bof EA, First Shekiang).

2. International Banks – Banks from the UK, USA, Japan, and SE Asian banks were free to operate in Hong Kong. (Citibank, StanChart, Dai-Ichi Kangyo, Bangkok Bank)

Origins, Cont.

3. Chinese State Banks – Chinese government set up banks in HK in pre-war era. After the revolution, these were taken over by PRC. Due to the isolation of PRC, these banks were the main link between the mainland and the world financial system (Bank of China, Nanyang Commercial)

4. Native Banks – Banks that serviced the rapidly growing retail markets for small deposits and loans during the immediate post-war migration of immigrants from the mainland (Hang Seng, Wing Lung, Dao Heng and many others)

Three Tier Structure

Hong Kong banking system is divided into 3 tiers.

1. Fully Licensed Banks: Intermediaries which can accept deposits of any maturity or size.

2. Restricted Licensed Banks: Intermediaries which can accept only very large deposits.

3. Deposit Taking Companies: Intermediaries which can accept only large deposits of lengthy maturity.

Current Industrial Structure

Licensed Banks Minimum Paid-Up Capital $150 Million Scope All Deposits Minimum Maturity of Deposits None Minimum Size of Deposits None Minimum Liquidity Ratio 25% Minimum CAR 8%, HKMA may Order rise to 12% Restricted License Banks Minimum Paid-Up Capital $100 Million Scope Time Deposits Only Minimum Maturity of Deposits None Minimum Size of Deposits $500,000 Minimum Liquidity Ratio 25% Minimum CAR 8%, HKMA may Order rise to 16% Deposit Taking Corporations Minimum Paid-Up Capital $25 Million Scope Time Deposits Only Minimum Maturity of Deposits Not Less Than Three Months Minimum Size of Deposits $100,000 Minimum Liquidity Ratio 25% Minimum CAR 8%, HKMA may Order rise to 16%

Fully Licensed Banks much more important than RLB’s & DTC’s August 2003

% of Assets

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

Domestic Banks "Foreign" Banks RLB DTC

% of Assets

Fully Licensed Banks

There are 155 fully licensed banks. Locally Incorporated: 31 Foreign Incorporated: 124

Before 2001, foreign incorporated banks were limited to 3 branches (a grandfather exceptions were made for foreign banks which were licensed in HK before 1978).

Consolidation: Prior to 2001, there had been no mergers of locally incorporated banks. In 2003, DBS Kwong On Bank took over Dao Heng to form DBS. Wing Hang acquired First Chekiang.

Market Dominance: More than 2/3’s of deposits are held at top 4 banks including HSBC, Hang Seng, Bank of China and StanChart.

Bank Deposit Market

Deposits of Customers Mill HK$Bank of America $27,508.00Bank of East Asia $140,817.00Bank of China $606,428.00Dao Heng $92,537.00Hang Seng $414,328.00HSBC $938,990.00International Bank of Asia $22,245.00Wing Hang $45,697.00Wing Lung $49,604.00

Major Changes in Regulatory Regimes

1948 – The first bank ordinance allows the governor to reject applications for bank licenses.

1964 - Banking ordinance created Commissioner of Banking to regulate banks, required 25% liquidity ratio which is still in effect.

1964 - Interest Rate Agreement creates the Banking Cartel

Major Changes Pt. 2

1981 DTC Ordinance Three Tier system formed.

1986 Risk based capitalization requirements imposed

1993 Exchange Fund merged with Commissioner of Banks to form HKMA.

Regulations

HKMA sets Minimum Standards for Authorization of banking institutions. Banks must have a minimum level of capital. HKMA does not allow non-financial conglomerates to own

banks. HKMA approves directors and chief executives, and

controllers.

HKMA conducts on-site and offsite examinations of banks books and records and an annual Prudential Meeting with bank decision makers. HKMA limits loans to any one customer or to directors. HKMA sets some rules governing bank liquidity and

capitalization. Banks must categorize their loans.

Why are Banks Regulated?

Because of the nature of the banking business, banks constantly face liquidity risk. Liquidity Risk: The possibility that depositors may

collectively decide to withdraw more funds than the bank has on hand.

Bank assets (loans) are less liquid that bank liabilities (deposits).

Maturity Mismatch

No matter how well a bank is managed or how good the credit quality of their loans, if all liquid deposits are withdrawn at once, banks could not raise enough liquid funds to pay all obligations.

Why do banks operate the way? Banks particular expertise is in analyzing and monitoring

long-term investment projects. Often expertise about a given project is specific to the bank itself and can’t be transferred. Banks loan portfolios are highly illiquid.

Banks have an asymmetric information advantage over their depositors. Depositors demand liquidity as a way to discipline banks from risky behavior.

Game Theory

In many economic situations, agents returns depend on the actions of other agents. In such a situation, agents must think strategically.

Economists use game theory to describe such situations.

John (“A Beautiful Mind”) Nash developed a concept called the Nash equilibrium.

Nash Equilibrium

A Nash equilibrium occurs when every player in a game is playing their best strategy given the strategy that the other players play.

Economists believe that outcomes of strategic situations are likely to be well-described by Nash equilibrium. Since every individual in a Nash eq. is playing there

best strategy given the actions of others, no one has any incentive to change their strategy individually.

Bank Depositors Game

Banks have very illiquid assets (loans) and obligations to repay their depositors in full at any time.

If all of the depositors at a bank withdraw their funds at the same time, the bank will have to sell their loans at a discount, and they will not have enough funds to pay all of their depositors.

If all of their depositors keep their money in the bank, most banks will be able to repay all of their depositors with interest.

Thus, the payoff to any individual depositor depends on what other depositors decide to do.

Bank Run Game: Withdraw or Don’t Withdraw Depositors each deposit $1000 at 10%

interest. They can choose to withdraw their funds

before collecting interest or keep their funds with the bank.

The right hand table shows pay-offs for each decision under two possible situations.

1. All other depositors keep their funds in the bank and the bank survives.

2. All other depositors withdraw funds and the bank must liquidate.

Payoffs1. If an individual keeps their funds with the bank

and everyone else does likewise, everyone gets their funds with interest.

2. If an individual doesn’t withdraw, but everyone else does, the bank will have nothing left to pay the individual who gets nothing.

3. If the individual depositor withdraws but no one else does, the depositor loses only interest.

4. If an individual depositor withdraws and everyone else does, they have some chance of getting some funds (say $500) back.

Individual Depositors Decision

All

Other Depositors

Decision

Withdraw Don’t

Withdraw

Withdraw Payoff:

$500

Payoff:

$0

Don’t

Withdraw

Payoff:

$1000

Payoff: 1100

Bank Deposit Game has Multiple Equilibria If no one else withdraws their funds, the best

strategy of any individual is not to withdraw their funds.

Thus, a situation in which no-one withdraws their funds and the bank pays interest to all is a Nash Equilibria.

If everyone withdraws their funds, an individuals best strategy is to withdraw before everyone else does.

Thus, a bank run, a situation in which everyone withdraws their funds and a bank is forced to liquidate its assets is also a Nash equilibrium.

Bank Runs The phenomenon in which all depositors compete to

withdraw their funds at the same time is called a bank run or a bank panic.

Depositors lack complete information about the value of banks assets.

If depositors believe that there is a significant fraction of loans which will not be repaid, depositors may have an incentive to immediately withdraw funds.

Bank deposits are first come, first serve. If you withdraw your funds before the bank declares losses you may not suffer at all.

Further, even if you believe that banks assets are sound you may have an incentive to immediately withdraw, if you believe that other depositors will also withdraw their funds.

Costs of Bank Panics

Bank runs can destroy the value of the illiquid assets of otherwise healthy banks or worsen the problems at banks suffering minor or major loan losses.

Panic is contagious. Since banks lend money to each other, a bank run at one bank may lead to beliefs that the resulting bankruptcy will affect the loan quality of other assets.

Banks play a large role in the financial intermediation system. A collapse in the banking system will disrupt lending.

Remedial Responses to Banking Panics

The damage from a banking panic are so severe that central banks often step in during a crisis and provide almost unlimited liquidity.

An emergency source of liquidity is the “lender of last resort.” Central banks are the natural lender of last resort as they can create infinite liquidity through their control of the money supply.

Before 1993, there was no central bank in Hong Kong. Role of lender of last resort was taken by note issuing banks.

Effects of Lender of Last Resort

The confidence brought by the knowledge that the central bank will provide liquidity in the case of a bank run, can actually reduce the chance that a bank run will occur.

Conversely, the fears of depositors of bankruptcies are an important source of discipline in the economy. A lender of last resort may encourage depositors to ignore the excessive risk taking of their banks, encouraging banks to take excessive risks.

Lenders of last resort encourages moral hazard.

HK Lenders of Last Resort

For most of HK’s history, the note-issuing banks (HSBC and Chartered) acted as the lender of last resort.

During banking crisis of 1965 sparked by collapse of a real estate bubble, HSBC and SC fully backed many local banks. Eventually HSBC took over Hang Seng.

During DTC crisis of 1981, sparked by collapse of a real estate bubble, HSBC and SC pledge vague support for DTC’s.

During bank crises of 1984-1986, the government took over various bankrupt banks, backing deposits with the Exchange fund.

Deposit Insurance (?)

In 1998, HKMA financial reform plan recommended studying introducing depositor insurance.

Under this scheme, depositors would receive reimbursement from the insurer for deposits below a certain amount if their bank fails.

Advantages: Small depositors need not make make withdrawals on the suspicion that their banks may fail.

Deposit Insurance: US Experience

Similar system in the United States has led to mixed results. After wide-ranging bank failures during the Great Depression, US implemented government subsidized insurance for small deposits in 1934.

Currently deposits less than US$100K (HK$800K) are insured against default risk.

Since part of banking risks are absorbed by the government, deposit insurance implemented with regulations on risk of bank lending.

Many credit this for stability of US banking system between 1930’s and 1970’s.

Savings and Loan Crisis

A system of small, but politically powerful banks that specialized in safe mortgage loans suffered financial damage from rising inflation in 1970’s.

Persuaded US government to cancel regulations on risky behavior but not cancel deposit insurance.

Result: Moral Hazard. S&L’s took on greater and greater risks in lending to real estate developers and other new ventures. Others were beset by massive corruption.

Total Cost to US Taxpayers US$145 billion.

Interest Rate Cartel

From 1965 to 2001, HK Association of Banks met on a regular basis to set rates for deposits of short maturity including checking and savings deposits.

Until July 2001, interest rates on small time deposit were set by HKAB. No deposits on checking accounts .

Reason: In 1950’s, competition for deposits led to low margin returns, low profits, and low capitalization levels. Stability of banking sector and high banking profits came at the expense of HK dollar depositors.

Loan Classification

HKMA requires authorized institutions to categorize their outstanding loans

1. Pass – Loans for which borrowers are current in meeting commitments and the full repayment of interest and principle is not in doubt.

2. Special Mention – Loans with which borrowers are experiencing difficulty.

3. Classified1. Substandard: Loans in which borrowers are

displaying a definable weakness.2. Doubtful: Loans for which collection in full is

improbable and the authorized institution expects to sustain a loss of principal or interest.

3. Loss: Loans that are considered Uncollectible.

HK Banking System: Loan Classification

Loan Classification: % of Total Loans Pass 87.62 Special Mention to Total 5.57 Classified: 6.81 Classified: Substandard 2.69 Classified: Doubtful 3.64 Classified: Loss 0.48

Property Market Collapse Leads to an Increase in NPL’s.

Jun-1995 Jun-1997 Jun-1999 Jun-2001

12

10

8

6

4

2

0

HK: Loan Ratio: Percentage to Total Loan: Classified: Gross%

Loan to Value Ratio

In November 1991, the banking sector voluntarily adopted a 70% loan to collateral value for residential mortgage lending.

HKMA adopted this as a guideline for mortgage lending.

Some homeowners are violating the “spirit of the law” by obtaining supplementery finance from non-bank sources.

Proactive Approaches to Bank Runs Regulations that require banks to maintain a

certain degree of capitalization and liquidity reduce the likelihood that the conditions for a bank run will occur.

If banks are highly capitalized, the owners invest their own money in the bank. The owners are the first to absorb any losses, reducing depositors exposure and incentive to withdraw funds in the face of shocks.

If banks are highly liquid, a sharp increase in withdrawals can be met without the costly liquidization of bank loans.

Hong Kong’s regulatory environment has emphasized minimum standards for liquidity ratios and capital adequacy ratios.

Liquidity ratio =

Hong Kong licensed banks are required to keep a liquidity ratio of 25%

monthMaturitywithsLiabilitie

monthMaturitywithAssetsAssetseLiquifiabl

1

1

Capital Adequacy Ratio

A simple measure of a bank’s capital adequacy is the ratio of banks capital to total assets. This measures what percentage of assets can be lost without presenting borrowers with losses.

Bank regulators recognize that many types of loans are less risky than others. HKMA requires that banks maintain a risk adjusted capital adequacy ratio of 8%.

The average CAR is 18%.

Capital Adequacy Ratio of HK Banks

Mar-1996 Mar-1997 Mar-1998 Mar-1999 Mar-2000 Mar-2001 Mar-2002 Mar-2003 Mar-2004

20.5

20.0

19.5

19.0

18.5

18.0

17.5

17.0

16.5

16.0

15.5

15.0

HK: Capital Adequacy Ratio%

Risk Adjusted Assets

The risk adjusted assets of a bank are a weighted some of loans and other assets, with the weights being an increasing function of risk.

A bank has n = 1, …, N assets. Asset n has a dollar value of Ln.

Total assets = L1 + L2 + ….LN

Regulators assign a weight to each asset, wn, that is increasing in the level of credit risk.

Risk adjusted Assets = w1L1 + w2L2 +….wN L3

Basel Approach to Credit Risk Bank for International Settlements (BIS) An

international organization founded in 1930 to foster international monetary and financial co-operation and serves as a bank for central banks

The BIS Basel Capital accord suggests a standardized set of weights for different types of banks assets.

Example:w Credit Rating

Borrowers AAA to AA- BBB+ to BBB- BB+ to B- Below B-Sovereign Borrowers 0 0.5 1 1.5Loans to Banks 0.2 0.5 1 1.5

AAA to AA- BBB+ to BB- Below BB-Corporates 0.2 1 1.5

Numerical Example: Solve for CAR

The Bank of Lending to Foreign Governments has capital of $25 billion and loans to the Singapore government, the South Korean Government and the Russian government of $100 billion each.

The capital to asset ratio is 1/12. The Singapore government has a AAA credit

rating. The South Korean government has a BBB credit rating. The Indonesia government has a CCC credit rating. The risk weighted assets of the BoLFG is (0*100)+(.5*100)+(1.5*100) = 200

CAR is .125.

Basel II

Leading international banks have negotiated a new capital accord.

Banks are required to have some share of their operating income as capital.

The new accord creates more sophisticated way of measuring credit risk. Banks must keep capital depending on assets and

operating income increasing capital requirements. Banks to apply their own credit models (based on

statistical analysis and valuation of collateral and hedging to their liabilities) This will likely reduce capital needed.

CAMELS Rating System

CAMELS is an international framework for grading banks (on a scale of 1 to 5) based on 6 factors.

1. Capital Adequacy

2. Asset Quality

3. Management

4. Earnings

5. Liquidity Risk

6. Sensitivity to Market Risk

Financial Innovation and The Decline of Traditional Banking Banking is traditionally the business of accepting

short-term retail deposits and making long-term loans.

A number of financial innovations have led to changes in the financial industry and financial regulation.

Due to reductions in information & transaction costs, the banking industry in US, Japan, and Europe faces competition for both deposits and credit.

Decline in Advantage in Providing LiquidityOne of banks biggest source of

comparative advantage is their ability to provide liquid assets for depositors. New Competition: Money Market Mutual Funds

– Mutual funds that are redeemable at a fixed price by writing checks. Mutual funds invest in money markets. These are essentially checking accounts issued by non-financial institutions that pay interest.

Decline in Advantage in Providing Credit Another of banks comparative advantage is their

ability to provide loans quickly and provide credit to small or new firms.

New Competition Commercial Paper: Short-term corporate bonds. Many

firms that relied on banks for short-term loans now issue commercial paper.

Junk Bonds: Bonds issued by firms with non-investment grade credit ratings. Many firms that relied on banks for credit now issue junk bonds.

If you can’t beat‘em, join’em

Banks have taken advantage of reduced information costs to find new sources of profits. Securitization – The process of transforming illiquid

assets into marketable securities. Banks will take a portfolio of loans (such as mortgages) and “bundle” them. They will then issue securities with a promise to pass on the repayment of the loans to the owners of the securities.

Off-Balance Sheet Activities – Banks provide promises of lines of credit to firms that participate in securities markets.

Challenge for HK Banks

Hong Kong economy has shifted toward entrepot trade.

HK businesses are integrating with mainland.

HK Banks cannot integrate fully due to Chinese regulations.

More reliance on property, less on commercial loans.

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

40.0%

Manufacturing

Transport and Transport Equipment (TE)

Electricity, Gas and Telecommunications

Bldg, Construction, Property Development &Investment (BC)

Trade

Financial

Residential

Other Private

2004

1990