1 Deregulation and the Hong Kong Banking Sector David Carse Hong Kong Monetary Authority 31 August 2001

2 The current situation of Hong Kong banks Banks are currently struggling to achieve profit growth –the economy is slowing down –loan demand is sluggish –lending margins are under pressure –bad debt provisions are falling, but not by as much as in 2000

3 Pre-provision operating profit and post-tax profit (local banks)

4 Net Interest Margin (local banks, annualised)

5 Customer deposits and loans for use in HK (local banks)

6 Competition Hong Kong banks are facing growing competition due to –global trends –increased emphasis on return on capital –lack of loan demand, particularly for residential mortgages –surplus domestic liquidity Regulatory initiatives have also played a part in removing potential barriers to competition –last stage of deregulation of HK$ interest rates took place on 3 July 2001

7 History of interest rate deregulation Phase one 1 October time deposits > 1 month 3 January time deposits > 7 days 1 November time deposits > 24 hours Phase two 3 July hour call deposits 3 July current and savings accounts

8 Banking sector reform Phase Two of interest rate deregulation is part of a banking sector reform programme announced in 1999 to cover period to end-2001 Objectives are to –promote greater efficiency and innovation in the market –enhance the safety and soundness of the banking sector –encourage consolidation of the industry through market forces Apart from interest rate deregulation, rules on entry of foreign banks have also been relaxed

9 Impact of latest round of deregulation Imposition of fees and charges Tiering of interest rates on savings accounts New types of account –interest-bearing current accounts (only one bank) –combined current and savings accounts –“auto-sweeping” service –HIBOR-linked savings accounts Most banks have now reduced standard savings rate (1.5%) by more than prime rate Limited evidence so far of switching of deposits between banks

10 Assessment of the impact so far Product innovation has happened as expected Other developments (like tiering of rates and fees and charges) were also expected –part of the process of more efficient pricing The surprise is that the savings rate has not risen as expected But this simply reflects the current surplus liquidity In the longer-term banks will probably compete more actively for deposits

11 Consumer protection The imposition of fees and charges has led to accusations of unfairness, particularly to small depositors However, HKMA does not believe that this justifies regulation of banks’ charging policies Main focus is on ensuring transparency on charging –Code of Banking Practice recently revised Banking Ombudsman may also be looked at Need also to monitor for possible signs of growing exclusion from the banking system

12 The way forward for the banks The economics of banking in Hong Kong are changing fundamentally This means that banks will have to do the following –broaden income sources (e.g. through sales of unit trusts, insurance etc) –control costs (e.g. through outsourcing of back offices) –improve risk management –consolidate through M&A –take advantage of the opportunities provided by the Mainland

13 Local Hong Kong banks’ presence in China Hong Kong banks count as foreign banks in China Currently, 11 HK banks have a total of 38 branches in 13 cities of China Mainly confined to foreign currency business with foreign companies and individuals Three banks have licences to do limited RMB business in certain cities

14 Relaxation under WTO Upon accession all restrictions on foreign currency business by foreign banks will be removed Within two years, foreign banks will be allowed to do RMB business with Chinese companies, subject to geographical restrictions which will be progressively relaxed Within five years, foreign banks will be able to do RMB business with all Chinese customers (including individuals) and geographical restrictions will be removed

15 Impact of WTO accession on Hong Kong banks (1) Banks in Hong Kong (both local and foreign) will benefit from increased demand for banking services in China This will result partly from the impact of WTO on China’s economic growth and partly from the liberalisation within China –ability and willingness of the Chinese public to use the banking system will increase

16 Impact of WTO Accession on Hong Kong banks (2) However, local HK banks will also face more competition for China-related business from both domestic Mainland banks and foreign banks Also, there is a risk that direct access by foreign banks to the Mainland will become more popular and that HK will be bypassed HKMA study suggests that creation effect of WTO will outweigh diversion effect But local HK banks cannot take this for granted –competition from Mainland banks is already evident

17 The impact of size Even with WTO relaxation most local HK banks will be limited in their ability to open new branches in the Mainland Current rules mean that only foreign banks with assets of at least US$20 billion can set up new branches Most HK banks are too small to meet this This is another reason why consolidation of the local banking system would be desirable

18 Conclusions The new deregulated environment in Hong Kong and the increased competition in a slowing economy are creating big challenges for banks These challenges are long-term and strategic in nature, apart from the immediate issue of how to achieve profit growth Hong Kong banks are strong and resilient But even so, structural changes in the form of industry consolidation are likely to be necessary