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 By the end of the day, depositors had withdrawn half of the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 Industry
1845: 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
Scope
Minimum Maturity of Deposits
Minimum Size of Deposits
Minimum Liquidity Ratio
Minimum CAR
Restricted License Banks
Minimum Paid-Up Capital
Scope
Minimum Maturity of Deposits
Minimum Size of Deposits
Minimum Liquidity Ratio
Minimum CAR
Deposit Taking Corporations
Minimum Paid-Up Capital
Scope
Minimum Maturity of Deposits
Minimum Size of Deposits
Minimum Liquidity Ratio
Minimum CAR
$150 Million
All Deposits
None
None
25%
8%, HKMA may Order
rise to 12%
$100 Million
Time Deposits Only
None
$500,000
25%
8%, HKMA may Order
rise to 16%
$25 Million
Time Deposits Only
Not Less Than Three Months
$100,000
25%
8%, HKMA may Order
rise to 16%
Fully Licensed Banks much more
important than RLB’s & DTC’s August
2003
% of Assets
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
Domestic Banks
"Foreign" Banks
% of Assets
RLB
DTC
Fully Licensed Banks
 There are 155 fully licensed banks.
 Locally Incorporated: 31
 Foreign Incorporated: 124
 Before 2001, foreign incorporated banks were limited to 3
branches (a grandfather exceptions were made for foreign
banks which were licensed in HK before 1978).
 Consolidation: Prior to 2001, there had been no
mergers of locally incorporated banks. In 2003,
DBS Kwong On Bank took over Dao Heng to
form DBS. Wing Hang acquired First Chekiang.
 Market Dominance: More than 2/3’s of deposits
are held at top 4 banks including HSBC, Hang
Seng, Bank of China and StanChart.
Bank Deposit Market
Deposits of Customers
Bank of America
Bank of East Asia
Bank of China
Dao Heng
Hang Seng
HSBC
International Bank of Asia
Wing Hang
Wing Lung
Mill HK$
$27,508.00
$140,817.00
$606,428.00
$92,537.00
$414,328.00
$938,990.00
$22,245.00
$45,697.00
$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



1.
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.
2.
All other depositors keep their funds in the bank
and the bank survives.
All other depositors withdraw funds and the bank

must liquidate.
Payoffs
1.
2.
3.
4.
If an individual keeps their funds with the bank
and everyone else does likewise, everyone gets
their funds with interest.
If an individual doesn’t withdraw, but everyone
else does, the bank will have nothing left to pay
the individual who gets nothing.
If the individual depositor withdraws but no one
else does, the depositor loses only interest.
If an individual depositor withdraws and everyone
else does, they have some chance of getting
some funds (say $500) back.
Individual Depositors Decision
Withdraw
Don’t
Withdraw
Withdraw
Payoff:
$500
Payoff:
$0
Don’t
Withdraw
Payoff:
Payoff:
1100
All
Other
Depositors
Decision
$1000
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. Classified
1. 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
Special Mention to Total
Classified:
Classified: Substandard
Classified: Doubtful
Classified: Loss
87.62
5.57
6.81
2.69
3.64
0.48
Property Market Collapse Leads to an
Increase in NPL’s.
HK: Loan Ratio: Percentage to Total Loan: Classified: Gross
%
12
10
8
6
4
2
0
Jun-1995
Jun-1997
Jun-1999
Jun-2001
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 =
Liquifiabl e Assets  Assets with Maturity
Liabilitie s with Maturity
 1 month
 1 month
Hong Kong licensed banks are required
to keep a liquidity ratio of 25%
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
HK: Capital Adequacy Ratio
%
20.5
20.0
19.5
19.0
18.5
18.0
17.5
17.0
16.5
16.0
15.5
15.0
Mar-1996
Mar-1997
Mar-1998
Mar-1999
Mar-2000
Mar-2001
Mar-2002
Mar-2003
Mar-2004
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 cooperation 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 AASovereign Borrowers
0
Loans to Banks
0.2
AAA to AACorporates
0.2
BBB+ to BBB0.5
0.5
BBB+ to BB1
BB+ to B1
1
Below BB1.5
Below B1.5
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.
2.
3.
4.
5.
6.
Capital Adequacy
Asset Quality
Management
Earnings
Liquidity Risk
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
Liquidity
One 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.
Other Private
Residential
Financial
Trade
2004
Bldg, Construction, Property Development &
Investment (BC)
1990
Electricity, Gas and Telecommunications
Transport and Transport Equipment (TE)
Manufacturing
0.0 5.0 10.0 15.0 20.0 25.0 30.0 35.0 40.0
% % % % % % % % %