Mr. Carse speaks on banking supervision in Hong Kong and the lessons learned
Speech by the Deputy Chief Executive of the Hong Kong
from the financial crisis in Asia
Monetary Authority, Mr. David Carse, at the Asian Investment Conference "Asia: Meeting the
Challenge" held in Hong Kong on 27/3/98.
1. I am pleased to be here this morning to speak to you on the topic of the supervisory
lessons which Hong Kong can learn from the region and specifically from the crisis which has engulfed
Asia since July of last year. This is a drama that is still being played out and we have not yet reached the
final act. But I do not think that it is too early to make some kind of judgment about what went wrong and
the lessons that can be drawn for the future.
The Asian Crisis
2. I think that it is fair to say that the Asian crisis has surprised almost everyone by its
speed and intensity and the ease with which it spread from country to country. Even those who were
sceptical about the Asian miracle did not really expect anything like this. Of course, there were
warning signs such as the current account deficits in a number of countries such as Thailand. But
these could be regarded as the natural consequence of the heavy demand for investment in growing
economies. The Asian economies were certainly not fault-free, but in general they not exhibit the
classic signs of gross macroeconomic weakness that normally lead to a balance of payments crisis.
Governments ran fairly prudent fiscal policies, savings were high and inflation rates reasonably low.
Even if policy mistakes were made, the punishment does not really seem to fit the crime.
3. Why then have exchange rates fallen by as much as they have and why have
economies in the region been so severely crippled? It is generally agreed that a large part of the
answer lies in the weakness of financial and banking systems in the region, which have amplified the
initial effects of external shocks and economic downturn. In essence, banking systems that were
already in weak health before the crisis broke were not up to the task of intermediating large inflows
of capital. They have been part of a vicious circle whereby loss of confidence in the currency leads to
loss of confidence in the banking system that further undermines the currency. This is the "run on the
country" syndrome. It therefore follows that strengthening of the banking system must be part of the
cure of the Asian disease and the means of preventing a recurrence. Banking supervision has an
important part to play in this strengthening - hence the topic of my speech today.
The weaknesses in Asian banking systems
4. Before I go on to discuss the supervisory lessons that can be learned, It is necessary
to consider in more detail the precise nature of the weaknesses that were apparent in some, though
not all, of the regional banking systems.
Over-expansion of bank lending
5. A number of economies experienced rapid growth in bank credit during the 1990s,
often fuelled by inflows from abroad. Much of this lending was made without proper credit
assessment and went into unproductive sectors such as property and the equity markets. This pushed
up asset prices and encouraged further lending. When capital outflows reversed (because of the
realization that exchange rates were over-valued) this led to a decline in asset prices which weakened
the position of both banks and borrowers. The resultant rise in bad debts undermined market
confidence in the solvency of the banking system, making it difficult for banks to roll over their
external borrowing and provoking further outflows. The weakness of the banks made them more
reluctant to lend, which further weakened the financial position of borrowers. This is the pattern,
which Paul Krugman has described as "financial excess and then financial collapse"1.
Excessive reliance on short-term foreign currency borrowing
6. What was particularly dangerous was that a combination of pegged exchange rates,
relatively high domestic interest rates and moves towards financial liberalization encouraged banks
in a number of economies to borrow heavily in foreign currencies to fund the lending boom. Much of
this borrowing was short-term, giving rise to a maturity as well as a foreign currency mismatch,
either on the part of the banks or the companies to which they on lent. When the initial pressure on
currencies emerged, domestic borrowers that had previously never had to think about hedging their
foreign currency liabilities rushed to do so, turning a slide in the currency into an avalanche. Those
who were too late were left with liabilities to the banks that were vastly inflated in terms of their
domestic currency - and the banks were left with the resultant bad debts and a crippled ability to
finance the routine needs of their customers.
Captive banks
7. Why were banks not more discriminating in their credit choices and decisions? Part
of the explanation is that in a number of economies banks were ordered or persuaded by the
government to lend heavily to particular industries and companies. In other words, they were
"captive banks". This allowed the companies concerned to become over-leveraged (and thus
vulnerable to economic downturn) and directed resources into unprofitable investments. The banks
concerned had little incentive to develop proper lending skills.
Concentration risks and connected lending
8. Moreover, banks in some economies were over-exposed to single borrowers, often
those connected with the lending institution. Such lending is usually of poor quality, not having been
made at arm's length, and means that the shareholders have no real capital at stake in the bank
(because it has effectively been lent back to them).
Failure to recognize bad debts
9. Having landed themselves with bad debts, banks failed to face up to the problem.
In particular, systems for loan classification and provisioning have been inadequate. As a result,
capital ratios have been overstated, and insolvent or near-insolvent banks have been allowed to
continue in business and to build up further losses. Banks have been allowed to accrue income on
non-performing loans, thus overstating revenue and capital.
Lack of transparency
10. All this has been made worse by a lack of transparency in regional banking
systems. Failure to disclose the true scale of bad debt problems has weakened market discipline on
bank management and reduced the need for them to face up to the problems. Public confidence in
banking systems has been undermined because, with no credible information, depositors and
investors assume the worse in even relatively sound banks and rush to take their money out.
Moral hazard
11. The final ingredient has been the perception that many banks in the region are
effectively government-guaranteed. This has created a problem of moral hazard whereby bank
management can afford to indulge in reckless lending behaviour because they believe that
government will bail them out if they fail. Similarly, depositors have less incentive to check the
creditworthiness of the banks with which they place funds.
Weakness in supervision
12. How did Asian banks get into this state of fragility? Inadequate regulation and
supervision, coupled with an explicit or implicit government guarantee, have attracted much of the
blame, leading Paul Krugman to describe Asian banks as "over-guaranteed and under-regulated".
Inadequate supervision cannot be the whole story since a number of the weaknesses arise from
circumstances which are not the direct responsibility of banking supervisors. There were some flaws
in macroeconomic policy, in particular the maintenance of unsustainable exchange rates. There was
undoubtedly also political interference in banks, in terms of both policy lending and pressure on
supervisors not to take action against well-connected owners of banks. Another fundamental problem
was weakness in the infrastructure of business laws that made it difficult for banks to take and realize
collateral and to put insolvent companies into liquidation. We must also bear in mind the fact that the
ultimate responsibility for poor lending and risk management practices must rest with the
management of the banks themselves. However, having said all this, there have undoubtedly been
failures in supervisory policies and practices, as demonstrated by the reform measures that are now
being put in place in a number of countries.
The Basle Core Principles
13. Reform is not an easy task. But at least supervisors in individual countries are
now in a position to tap into an international network of technical cooperation and assistance to help
them to bring their systems up to scratch. At the centre of this international effort is the Basle
Committee on Banking Supervision which is taking on a leadership role in devising supervisory
standards that can apply to all countries and not just the G-10 countries which sit on the Committee.
In particular, the Committee has produced a set of Core Principles that are intended to provide a set
of minimum requirements for effective banking supervision. Supervisory authorities around the
world are being encouraged to endorse the Core Principles and to implement them as quickly as
possible. The IMF will have a role to play in checking that countries are indeed taking serious steps
in this direction.
14. The Core Principles are not earth shattering. They have not unveiled some new
secret of how to supervise banks. All they do is to summarize what are generally agreed to be the
fundamentals of a sound system of supervision. This includes the following main elements:
• Clear responsibilities and objectives for the supervisor set out in a suitable legal
framework
• Operational independence for the supervisor and the necessary resources to do
the job
• A proper licensing regime for banks
• Sound prudential regulations and requirements that address the main types of
risk faced by banks
The means to enforce supervisory requirements and gather information through
•
on-site examination and off-site review
• The power to take action against problem banks, including closure
• The ability to conduct consolidated supervision and to cooperate and exchange
information with other supervisors at home and abroad
15. These may seem like statements of the obvious. But the necessary measures were
evidently not fully in place in a number of countries in the region. Reforms are now being
implemented, in some cases with the help of the IMF and the World Bank. These include tighter
limits on loan growth and on lending to sectors such as property; tightening of the loan classification
framework and provisioning requirements; more disclosure of non-performing loans; strengthening
of on-site examination to introduce a more risk-based approach; and enhanced legal powers for the
supervisors to take prompt action to deal with problem banks. In a number of countries, problem
banks and finance companies have been closed down or are being merged and efforts are being made
to realize as much value as possible from their bad assets. From my discussions with my supervisory
colleagues in the region I know that they are serious in their efforts and I wish them every success.
The lessons for Hong Kong
16. This sentiment recognizes that it is also in Hong Kong's interest that financial
stability returns to the region. As I have already indicated, one of the special features of the Asian
disease is that it has been extremely contagious. And although the Hong Kong economy and
financial system have remained in pretty good health, they have not been totally immune. This
suggests that we too have lessons to learn from the crisis.
17. Hong Kong's supervisory system does indeed compare well with international
standards. A review which we conducted last year showed that we had addressed all the areas
covered by the Basle Committee's Core Principles and that we fully complied with all but a few of
them. In the latter cases, we are in partial compliance. This does not however mean that we can be
complacent for the following reasons:
• First, the Basle Core Principles are, as I have indicated, minimum standards
and we should where possible be aiming for best practice
• Second, the environment being faced by banks is changing at an accelerating
rate and we need to be sure that our supervisory system keeps pace with this
• Third, even our robust monetary system can be subject to external shocks and
the banks need to take this into account in the way in which they manage their
business.
18. The latter point needs some further elaboration. As you will be aware, Hong
Kong's monetary policy is built around exchange rate stability in the form of the link between the
Hong Kong dollar and the US dollar. This is backed up by the currency board system which requires
the monetary base of the banking sector - the notes and coins in circulation and the clearing balances
held with the HKMA - to be fully backed by foreign currency. When the Hong Kong dollar is under
pressure as it was at the end of October 1997 and again in January of this year, the HKMA buys
Hong Kong dollars from the banks in exchange for US dollars and the monetary base shrinks. This
tightening of liquidity will in turn cause interest rates to rise, perhaps sharply so. This will choke off
the inflows and restore stability to the exchange rate.
19. It is important to realize that this is an automatic process and that the HKMA has
no room to maneuver to prevent the rise in interest rates from taking place. To do so would run
counter to the basic principle of the currency board and would risk prolonging any attack on the
Hong Kong dollar.
20. I think that there is now a better understanding of how the currency board system
works. In addition, our determination to adhere to the system and to defend the linked exchange rate
has been clearly demonstrated. This should help to deter future speculative attacks on the Hong Kong
dollar. However, we have to acknowledge that the possibility of short term interest rates shocks does
exist under the currency board mechanism and the banks therefore need to take this into account in
the way in which they run their business and manage their balance sheets.
21. Bearing this in mind, I draw three main supervisory lessons from the regional
crisis and its impact on Hong Kong:
• First, it is important for banks to maintain a strong balance sheet that can
withstand the interest rate fluctuations to which I have referred and maintain the
confidence of the public. Banks in Hong Kong score well in this respect but it is
not something that can be taken for granted. I think that it is true to say that some
banks did expand their loan books too rapidly during the mortgage boom in 1997.
As a result, loan to deposit ratios came under some strain. The banks were also
exposed to growing interest rate risk because a substantial proportion of their
assets are linked to best lending rate while their liabilities are linked to HIBOR.
This has been a reminder of the need to maintain sound fundamentals: high capital
adequacy and liquidity ratios; prudent loan classification and provisioning; and
sound risk management.
• A second and related lesson from the region is that banks need to beware of
excessive lending to finance overheated asset markets. This increases the leverage
of their customers, exposing the banks to increased credit risk if prices fall. This of
course is what has happened in the property market in Hong Kong, although the
banks have so far been protected by their prudent lending policies and by the fact
that much of their property exposure is related to the residential market.
Notwithstanding the good outcome so far, we believe that the Asian crisis has
reinforced the need for restraint in the growth in property lending and in other
forms of asset-based finance, such as share margin financing and taxi loans.
• The third lesson is that increased disclosure and transparency are necessary to
reduce market uncertainty and limit the risk of contagion. The disclosure of bad
news can be uncomfortable, but it does serve the useful function of putting
pressure on management to run their business prudently and to deal quickly with
any problems which may arise. Hong Kong has made considerable progress in
recent years in terms of disclosure of information by banks. We intend to build on
this during the course of 1998 by recommending new measures such as more
disclosure about non-performing loans and more specific guidelines for income
recognition by banks.
Review of the Hong Kong banking sector
22. We will be building these lessons into our supervisory approach during the course
of 1998. More generally, as I have already mentioned, we also have to ensure that our approach
keeps up with market developments and takes account of new types of risk that may emerge. For this
reason, we have recently commissioned a firm of consultants to carry out a study of the banking
sector in Hong Kong over the next five years.
23 The study has two objectives. The first is to examine the strategic outlook for the
banking sector in Hong Kong during the five-year period. This will include an assessment of the
strengths and weaknesses of the banking sector and the opportunities and threats with which it is
faced, taking into account the impact of global and local trends and issues. Among the issues to be
examined will be the costs and benefits of certain features of the current regulatory system (such as
the remaining interest rate rules and the one branch policy) and the potential impact of changes to
these features. I should add however there is no presumption that changes to the current regulatory
system should, or will, be made. We are going into this with an open mind.
24. The second objective of the study is to consider the adequacy and effectiveness of
the HKMA's current approach to banking supervision and to make recommendations for any
changes that seem required in the light of the strategic outlook for the banking sector. This would
include any changes that needed to be made to the organizational structure of our supervisory
function within the HKMA and the supervisory policies, guidelines and techniques which we use.
The study will also examine whether we have the necessary resources to do the job.
Conclusion
25. In conclusion, the Asian crisis has been a major "wake-up" call to supervisors in
the region and has given fresh impetus to international efforts to raise supervisory standards. One
point which bears repeating however that tightening of supervision is not the whole answer,
particularly if the effect is simply to impose more rules on the banks. More external regulation may
indeed have to be the short-term response in a number of countries, particularly those where blanket
government guarantees have been given to depositors. However, the long-term solution must lie in
devising a supervisory approach which gives the right incentives for management of banks to take
responsibility for their own actions.