Norman T L Chan: Universal banking - Hong Kong's perspective
Keynote address by Mr Norman T L Chan, Chief Executive of the Hong Kong Monetary
Authority, at the opening session of the Asian Banker Summit 2011, Hong Kong,
7 April 2011.
* * *
Distinguished guests, ladies and gentlemen,
1. I am very pleased to address this important conference this morning as it provides a
timely occasion for us to take stock of what is happening to our banking industry at a time
when the international financial markets are recovering from the Global Financial Crisis.
Indeed, the landscape of banking has undergone very significant changes since the eruption
of the crisis in 2008. And more changes are in store. Some might even argue that banking
will evolve beyond recognition when compared with what we knew previously. Of course the
international banking reform package, ranging from the new capital, liquidity and leverage
regime under Basel III, the treatment of Global Systemically Important Financial Institutions
to the use of macro-prudential tools etc, will have different implications for different banks
and different jurisdictions. It is not my intention to discuss today the new international
standards that have been and are about to be adopted as these standards have been talked
about very frequently amongst bankers and regulators. What I would like to do here is to
share with you our views on the following three issues that have profound impact on the way
in which the banking industry, including that in Hong Kong, should structure itself:

Universal Banking vs. Segregated Banking

Universal Banking vs. Narrow Banking
 Branch vs. Subsidiary Operations.
Universal banking vs. segregated banking
2. First let me talk about "universal banking", which may mean different things to
different people. By "universal banking" I refer to a business model in which banks are
allowed to provide a wide range of banking and other financial services to their customers,
whether they are mass retail, high net-worth, SMEs or large corporates. In this connection, it
may be appropriate to regard a universal bank as a one-stop financial supermarket.
3. Hong Kong has a long tradition of this type of universal banking. Notwithstanding the
experiences of the recent Global Financial Crisis and the ongoing debate and scepticism in
some jurisdictions, we continue to see merit in the model of universal banking. Why? Let me
explain.
4. First of all, universal banking in the form of a one-stop financial supermarket
provides what the customers need to meet their rising demand for investments in a wide
range of financial and wealth management products. These customers can enjoy the
convenience of a one-stop service, ranging from simple products such as equities, unit
trusts, insurance, gold etc. to the more complex derivative or structured products that meet
their investment needs. At the same time, universal banking also allows some banks, if they
have the resources and expertise, to provide corporate or investment banking services to the
more sophisticated corporate clients in a wide range of areas such as debt finance, equity
fund raising, mergers and acquisitions and other advisory services.
5. Universal banking also makes a great deal of sense from a bank's point of view.
Under this model, a bank will be able to better serve the diverse needs of its customers, and
generate fee and commission income which is not subject to the same kind of credit, maturity
and other risks associated with income derived from lending and trading activities.
Customers need the services and banks provide them: it does look like a perfect match,
doesn't it? As always, perfection rarely exists in the real world and there is a catch inherent in
this one-stop financial supermarket model. This is related to the different ways in which
customers perceive a bank as a deposit-taking institution versus a brokerage house or
investment bank.
6. Because of the easy access and convenience universal banks offer, they tend to
attract customers along a very wide spectrum of financial sophistication and risk appetite.
Some of these customers go to banks to conduct very basic banking transactions, such as
cash withdrawal, rolling over fixed deposits, remittances, applications for loans, getting
cheque books and credit cards etc. As universal banks seek to expand fee and commission
income in distributing investment products, there may be a risk that some banks or their
frontline staff could become overly keen to market products to customers without sufficient
regard to the customers' own circumstances. Closer to home, the Lehman Minibonds
episode has reminded us of the need for banks to take great care in the marketing and
distribution of investment products to customers. It is for this reason that some have argued
that the banking industry should revert to a simpler model of basic banking and leave the rest
to brokerage houses and financial advisors.
7. The Global Financial Crisis and the subsequent international debate have prompted
us to reflect on whether universal banking still remains an optimal model of banking for Hong
Kong. Our answer is "yes". But, this is a qualified "yes" because we believe that banks must
take two appropriate steps to address the potential concerns that I have just highlighted:
(a) Banks should offer their retail customers a high degree of protection with adequate
regard to their interests or experience in investing in securities or other structured products.
That is why the HKMA has required banks, in selling investment products to customers, to
adopt extra investor protection measures on top of those promulgated by Hong Kong's
Securities and Futures Commission. These extra protection measures include audio
recording of the marketing process, segregation of investment corner from the main banking
hall or counters, and a mandatory 2-day pre-investment cooling off period for vulnerable and
inexperienced investors.
(b) Banks must take extra care in marketing and distributing investment products to
their customers. They must remain vigilant throughout the entire distribution process, from
product due diligence, risk assessment of the products, suitability assessment of the
customers, training for the frontline staff and control and governance of the sales process.
Universal banking vs. narrow banking
8. Let me move to the second issue, with a different meaning attached to the phrase
"universal banking". Here, "universal banking" refers to a business model in which banks are
allowed to conduct their own proprietary trading and market making in addition to trading on
behalf of their customers and offering other traditional banking services and products. This is
another area which has attracted heated debate and a diversity of views.
9. We've seen the Volcker Rule in the US and we've heard the Governor of the Bank
of England speak out in favour of narrow banks. Their concerns spring from the potential
ability of the universal banks to leverage their cheaper sources of funds obtained from public
deposits for risky ventures to raise the return on equity and to meet ever rising shareholders'
expectations. As banks expand their risk taking activities, both on balance sheet and off
balance sheet, some banks have become much larger and more complex, thereby rendering
themselves "too big to fail".
10. On the other hand, the proponents of universal banking note that diversification can
be beneficial for banks and banking stability. If one area of business underperforms, others
can make up for it - making the "whole" more resilient. It can also be argued that banks that
are diversified in terms of businesses or geographical operations are better positioned to
offer customers the depth and breadth of services these customers require, particularly as
economic activities become ever more specialised and global. Broadening customer access
to financial products enables increased flows of savings through the system, facilitating
efficient investment and economic growth. These advantages are not to be dismissed lightly.
11. The HKMA takes a balanced and pragmatic view on this issue. Rather than
mandating the dismantling of banks' business structure to deal with the potential problems
arising from proprietary trading and overly aggressive risk taking by banks, our preferred
response is to ensure the proper risk capture and management of those parts of the
operations that benefit from low cost funding and yet cause a disproportionate amount of
risk. As part of our on-going supervision we need to critically assess whether banks really
understand what sort of risks they are taking on and seek to ensure that such risks are
managed properly in order to safeguard depositors' interests.
12. As I said earlier, we have a long tradition of universal banking in Hong Kong and we
have not seen our universal banks turn into aggressive trading and sales outfits or principal
risk-taking hedge funds. But we can definitely see the potential danger. We therefore need to
ensure that our banks do not take on excessive risks in their chase for higher profits and
bonuses. Banks holding customer deposits must keep their responsibilities to their depositors
foremost in their minds and not allow their proprietary trading or i-bank activities to
overshadow these responsibilities. If they fail in this regard, they will make the case for
narrow banking themselves.
Branch vs. subsidiary operations
13. Another strand coming out of the debates on banking structure relates to the
question of whether banks should be required to operate in host jurisdictions as subsidiaries.
There are two angles to be considered here: supervision and resolution. Some jurisdictions
have taken the view, long before the Global Financial Crisis, that overseas banks operating
in their jurisdictions should take the form of subsidiaries rather than branches. The main
motivation, as I understand it, is that the host supervisors will have a much stronger
regulatory handle, such as capital requirements, prudential limits, auditing, etc, to supervise
a locally incorporated subsidiary than a branch. In a resolution scenario, many also favour
subsidiarisation because it provides a clear legal entity structure which is easier to handle
nationally under an insolvency situation.
14. But subsidiarisation is far from being the panacea for all ills. Many have argued that
subsidiaries offer sub-optimal use of bank capital, which will be split up and locked up in
separate geographical pockets or jurisdictions. In times of stress they could not so readily
rely on parent level support or the home central bank. The inability of subsidiaries of
international banks to leverage on the capital of their parents would limit their lending in
many emerging market economies. This may in turn have negative impact on the trade,
investment and other economic activities of these emerging market economies. Besides,
liquidity management would likely be more efficient for a branch than for a subsidiary as
funds can flow more freely within the same legal entity. On resolution, it is true that the
insolvency proceedings for a subsidiary would normally be simpler than for a branch, but in
practice there could be many complications such as: linkages to other group entities through
intragroup guarantees and exposures, service reliance and shared management, to name
but a few issues, which would affect the ultimate resolvability of a subsidiary when it actually
happens.
15. After the Global Financial Crisis, the subsidiarisation model has actually gained
greater support in some jurisdictions. This is because some home supervisors of
internationally active banks feel that it might be easier for these international banks to
undertake "de-risking" operations should trouble occur in overseas subsidiaries than in
branches.
16. From Hong Kong's perspective, we believe that subsidiaries and branches of
overseas banks can and do play different roles in servicing the real economy. The HKMA
takes the view that an overseas bank that wishes to undertake retail business in Hong Kong
should operate in the form of a locally incorporated subsidiary. This is to offer appropriate
protection to the retail depositors in Hong Kong and to do that the HKMA needs to have an
effective supervisory handle on every aspect of a retail bank's operation, especially its capital
adequacy ratio. We cannot achieve this if the bank operates as a branch in Hong Kong.
17. However, we also recognise that subsidiaries may not necessarily be an efficient
model of operation if an overseas bank intends to undertake only corporate or private
banking in Hong Kong. For example, a branch can leverage on the capital of the entire bank
to finance a loan for a large corporate, which would otherwise be impossible if it operated as
a subsidiary with rather limited capital in Hong Kong. Likewise, some private banking clients
may prefer to deal with or book their investments with a branch of an overseas private bank
rather than a subsidiary of that bank. So the HKMA keeps an open mind on whether an
overseas bank operating in Hong Kong should take the form of a subsidiary or a branch. It all
depends on the business model of the bank concerned. To take it one step further, we are
prepared to take a liberal view if an overseas bank wishes to engage in both retail banking
through a subsidiary and, in parallel, corporate or private banking that would more
appropriately be conducted through a branch. We have had several precedent cases and the
HKMA is prepared to consider applications on the basis of the merit of the case.
18. While we maintain an open mind on the use of branches by overseas banks, we
have to take steps to mitigate the potential risks arising from cross border contagion. This is
particularly important given that Hong Kong is a net provider of funds, i.e. our banks collect a
lot more customer deposits than they lend out locally. Hong Kong therefore has to closely
monitor intra-group or inter-bank funding that flows from Hong Kong to overseas centres. We
have seen in the Global Financial Crisis very clearly how wholesale funding through this kind
of cross border intra-group or inter-bank channels may be susceptible to significant shocks in
times of market stress. The problem could be exacerbated if the host supervisors, in
selfdefence, sought to ring-fence domestic liquidity by blocking the flow of funds at the most
difficult time. So the HKMA has been in discussion with banks in Hong Kong on how best
they could achieve a better match between liabilities derived from Hong Kong and assets
booked in Hong Kong. This should help reduce the scale of and reliance on cross-border
fund flows, which should contribute to greater financial stability while preserving the flexibility
of global banks to operate in branch mode in overseas jurisdictions.
Conclusion
19. Ladies and gentlemen, in conclusion, I would like to make just one last comment.
The world's financial system has become ever more complex and inter-connected. It is safe
to say that there is no "one size fits all" answer to what kind of business model banks should
adopt as a universal rule. Each jurisdiction must therefore reflect and determine on its own
what kind of banking model that would suit them best, having regard to their own
circumstances and needs. No doubt there will be new international standards that all banks
must comply with in order to make banks individually and collectively more resilient.
However, robust standards and rules are not in themselves enough to prevent big mistakes
and crises: they must be supported by sound and forward looking supervision. This is easier
said than done in a universal banking model, as bankers and traders are often miles ahead
of the regulators and supervisors when it comes to financial engineering and innovations
which, as we have found out in the Global Financial Crisis, may not necessarily contribute to
better risk management of banks and overall financial stability. Recognizing this inherent risk,
the HKMA, in seeking to nurture the universal banking model in Hong Kong, must continue
with its long standing conservative supervisory approach with even greater emphasis on
prudence under-pinned by proactive and forward looking supervision.
20. Ladies and gentlemen, this is a rather long speech and I thank you for your kind
attention. Thank you!