Lecture 13: Analysis of Banking Regulation

Asymmetric Information and Banking Regulation

Government Safety Net and Deposit Insurance (Deposit Protection Scheme)

The deposit protection scheme (DPS) in Hong Kong commenced operation on 25 September
2006. It is established under the Deposit Protection Scheme Ordinance. It reduces the
probability of failure by reducing the risk of rumor-driven runs; it protects and provides an
orderly means of compensating depositors (including both individuals and companies) of the
failed bank (a Scheme member) in the event of a bank failure; and reduces the fall-out effects
of a bank failure.

The objective of introducing the DPS is to contribute to the stability of the banking system -
“List of Authorized Institutions (AIs) under the supervision of the Hong Kong Monetary
Authority (HKMA) through the provision of protection to depositors”.

There are enhancements which will take effect on 1 January 2011, immediately after the full
deposit guarantee provided by the Government expires. The major enhancements contained
in the Amendment Ordinance include:

 raising DPS protection limit from HK$100,000 to HK$500,000;

 protecting secured deposits to enhance the clarity of DPS coverage;
 introducing cost mitigating measures to avoid the cost of providing better protection being
transferred to depositors; and
 improving the efficiency of the Board in calculating and making compensation to
depositors in a payout.

Both Hong Kong dollar and foreign currency deposits are protected. However, restricted
licensed banks and deposit-taking companies are not members of the Scheme and therefore
deposits placed with them are not eligible for protection. In addition, other financial products
such as bonds, structured deposits, term deposits with a maturity exceeding 5 years, off-shore
deposits, deposits held for the account of the Exchange Fund, stocks, warrants, mutual funds,
unit trusts and insurance policies other than deposits are also not protected.

Imperfection:

 Prevents bank runs due to asymmetric information: depositors can’t tell good banks from
bad banks.
 Creates moral hazard incentives for banks to take on too much risk.
 Creates adverse selection problem of crooks and risk-takers wanting to control banks.
 Too-Big-to-Fail increases moral hazard incentives for big banks and is unfair.
“Too Big to Fail” is a phrase referring to the idea that in economic regulation, the largest
and most interconnected businesses are so large that a government could not allow them to
fail because such failure would have a catastrophic effect on the economy. The benefits of
a too-big-to-fail policy are that it makes bank panics less likely. The costs are that it
increases the incentives of moral hazard by big banks who know that depositors do not
have incentives to monitor the bank's risk-taking activities. In addition, it is an unfair
policy because it discriminates against small banks.

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Restrictions on Asset Holdings & Bank Capital Requirements

 Reduces moral hazard of too much risk taking.

 Leverage ratio = Capital / Total Assets
Low leverage ratio triggers increased regulatory restrictions on the bank.
 Risk-based capital requirement, a minimum capital standard, links to off-balance-sheet
activities such as interest-rate swaps and trading positions in future and options.

Bank Supervision: Chartering and Examination

 Chartering banks is the bank regulation that helps reduce the adverse selection problem
because it attempts to screen proposals for new banks to prevent risk-prone entrepreneurs
and crooks from controlling them. It will not always work because high-risk people have
incentives to hide their true nature and thus may slip through the chartering process.
 Prudential supervision
 Reduces adverse selection problem of risk takers or crooks owning banks.
 Reduces moral hazard by preventing risky activities
 The primary purpose of CAMEL, an internationally recognised framework for assessing
the Capital adequacy, Asset quality, Management, Earnings and Liquidity of banks, is to
help identify institutions whose weaknesses require special supervisory attention. The
overall rating is expressed on a scale of 1 to five in ascending order of supervisory
concern.

Disclosure Requirements

Better information reduces asymmetric information problem.

Consumer Protection

 Standardized interest rates, e.g. annual percentage rate, and the total finance charges on
the loan, and other related information have to been provided by all lenders.
 Prevent discrimination.

Restrictions on Competition to Reduce Risk-Taking

 Increased competition can increase moral hazard incentives for banks to take on more risk.
 Branching restrictions and separation of banking and securities industries.
 But it led to higher charges to clients and decreased the efficiency of banking institutions.

Authorisation of Authorised Institutions (AIs

Under the Banking Ordinance, the HKMA is the licensing authority responsible for the
authorisation, suspension and revocation of all three types of authorised institutions.
Banking business means the business of either or both of the following:

 receiving from the general public money on current, deposit, savings or other similar
account repayable on demand or within less than three months;
 paying or collecting cheques drawn by or paid in by customers.

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The Three-tier Banking System

Hong Kong maintains a three-tier system of deposit-taking institutions, namely, licensed

banks, restricted licence banks (RLBs), deposit-taking companies (DTCs). They are
collectively known as authorized institutions (AIs). At the end of Dec. 2017, Hong Kong had
155 licensed banks, 19 RLBs, 17 DTCs and 49 local representative offices. 70 of the largest
100 banks in the world have an operation in Hong Kong.

 Only licensed banks may operate current and savings accounts, and accept deposits of any
size and maturity from the public and pay or collect cheques drawn by or paid in by
customers in Hong Kong. The aggregate amount paid-up share capital and the balance of
its share premium account of a company is at least $300 million or an equivalent amount
in any other approved currency. Balance sheet size criteria are currently HK$3 billion for
customer deposits and HK$4 billion for total assets.
 RLBs are principally engaged in merchant banking and capital market activities. They
may take deposits of any maturity of HK$500,000 or above. The aggregate amount of its
paid-up share capital and the balance of its share premium account is at least $100 million.
 Deposit-taking companies DTCs are mostly owned by, or otherwise associated with,
banks. These companies engage in a range of specialised activities such as consumer
finance and securities business. They may take deposits of HK$100,000 or above with an
original term of maturity of at least 3 months. The aggregate amount of its paid-up share
capital and the balance of its share premium account is not less than $25 million.

Regulatory and Supervisory Framework

Supervisory Objective

The Banking Ordinance provides the legal framework for banking supervision in Hong Kong.
The principal function of the HKMA is to “promote the general stability and effective
working of the banking system.” The Basel Committee on Banking Supervision (BCBS) (巴
塞 爾 銀 行 監 管 委 員 會 ) develops guidelines and supervisory standards to enhance
understanding of key supervisory issues and improve the quality of banking supervision
worldwide. The aim of Basel III is to improve the banking sector’s ability to absorb shocks
arising from future financial and economic stress.

Regulatory Requirements

The Banking Ordinance requires AIs to maintain adequate liquidity and capital adequacy
ratios, to submit periodic returns to the HKMA on the required financial information.

Supervisory Approach

The HKMA follows international practices as recommended by international standard-setting

bodies, such as the Basel Committee on Banking Supervision, to supervise authorized
institutions. The approach, aims at detecting any problems at an early stage, is based on a
policy of “continuous supervision”, through on-site examinations, off-site reviews, prudential
meetings, co-operation with external auditors and sharing information with other supervisors.
The “CAMEL” rating system is adopted to help identify those institutions whose weaknesses
in financial condition, compliance with laws and regulations, and overall operating soundness.

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On-site Examination and Off-site Review and Tripartite Meeting with External Auditors

Examination ranges from an investigation of specific areas to a comprehensive review of an

institution’s operations. Periodical on-site examinations provide an opportunity to assess at
first hand how an institution is managed and controlled. They are supplemented by on-going
off-site analyses of the financial state and the assessment of the quality of their management,
including the policies and systems in managing risks to achieve “continuous supervision”.
Annual tripartite discussions are increasingly held with institutions & their external auditors,
normally upon the completion of annual audits.

Derivatives and Risk Management

A proactive three-pronged approach: (i) controls (to ensure that AIs have adequate internal
control systems to manage the risks of their derivatives activities) (ii) capital (to ensure that
AIs have adequate capital to support possible losses in their derivatives business); and (iii)
capability (to ensure that there is adequate expertise within the HKMA to develop risk
management policies and to supervise AIs’ derivatives activities).

Financial Disclosure Standards in Hong Kong

AIs (except for the smaller RLBs and DTCs) are required to disclose certain quantitative and
qualitative financial information (both on an interim and annual basis) relating to their income
statements and balance sheets. Depositors and shareholders are provided with relevant,
reliable and timely information on banks to enable them to assess banks’ performance.
Increased transparency demonstrates the financial strength of the banks to financial analysts
and credit rating agencies and enhances Hong Kong’s as an international financial centre.

Collection of financial information

An institution is required to submit returns or other information on assets and liabilities, profit
and loss, capital adequacy, liquidity, large exposures, loan classification, foreign exchange
position, interest rate risk, market risk and include a certificate of compliance with various
requirements under the Banking Ordinance on both a (routine) regular and periodic basis and
ad hoc basis. In addition, the HKMA may require any holding company or subsidiary or
sister company to submit such information as may be required for the exercise of his functions
under the Banking Ordinance. Submission of returns is normally made each month or quarter.

Capital Adequacy

Capital Adequacy Ratio (CAR) is a ratio of a bank’s capital base to its risk-weighted assets.
The ratio is intended to be a measurement of a bank’s capital position in respect of its
exposures to credit risk, market risk and operational risk. Bank depositors and creditors prefer
capital as bank capital absorbs losses before depositors or creditors absorb losses.

Supervision of Liquidity

The adequacy of an institution’s liquidity is assessed having regard to six factors, including
liquidity ratio, maturity mismatch profile, ability of the interbank market borrowing, intra-
group transactions, loan to deposit ratio, and diversity and stability of the deposit base.
Sufficient high quality liquid assets provide a breathing space in the event of a liquidity crisis.

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Description of Key Risks

 Credit Risk: The risk arising from the potential that a borrower or counter-party will fail to
perform on an obligation. The treatment of credit risk for regulatory capital is different
from Basel I through to Basel III.
 Liquidity Risk: Institution may be unable to meet its obligations as they come due because
of an inability to liquidate assets or obtain adequate funding (funding liquidity risk) or that
it cannot easily unwind or offset specific exposures without significantly lowering market
prices because of inadequate market depth or disruptions (market liquidity risk)..
 Market Risk: The risk to an institution’s condition resulting from adverse movements in
market rates or prices, such as foreign exchange rates, or commodity/equity prices.
 Interest Rate Risk: The risk to an institution’s financial condition resulting from adverse
movements in interest rates.
 Operational Risk: The risk arising from the potential that inadequate information systems,
people procedures, operational/transactional problems (relating to service or product
delivery), breaches in internal controls, fraud will result in unexpected losses.
 Strategic Risk: Adverse business decisions, improper implementation of decisions, or lack
of response to industry changes have impact on earnings or capital.
 Legal Risk: The risk arising from the potential such as unenforceable contracts, lawsuits
or adverse judgment may disrupt or negatively affect the operations or financial condition.
 Reputation Risk: The potential that negative perception, opinions, beliefs, and publicity
regarding an institution's business practices, whether true or not, will cause a decline in the
customer base, costly litigation or revenue reductions. It is a softer risk.
 Technology Risk: As increase dependency on technology resources to deliver banking
services, inappropriate usage may have significant risk implications. For example: the
strategic risk resulted from poor decisions on technology-related investments; the
operational risk caused by unauthorized access or disruptions to technology resources; the
reputation risk and the legal risk due to material security breaches or unavailability of
computer systems which process customers information and transactions.

Loan Classification System

The HKMA introduced a loan classification system, which enhances the understanding of the
asset quality of individual institutions and to provide an overview of the asset quality of the
banking industry as a whole, requiring AIs to report their assets on a quarterly basis according
to a standardised framework. Under the system, loans are classified as:

Pass: Loans for which borrowers are current in meeting commitments and for which the full
repayment of interest and principal is not in doubt. Special Mention: Loans with which
borrowers are experiencing difficulties and which may threaten the authorized institution's
position. Substandard: Loans in which borrowers are displaying a definable weakness that is
likely to jeopardise repayment. Doubtful: Loans for which collection in full is improbable
and the authorized institution expects to sustain a loss of principal and/or interest, taking into
account the net realisable value of collateral. Loss: Loans that are considered uncollectable
after all collection options (such as the realisation of collateral or the institution of legal
proceedings) have been exhausted. The last three categories collectively regarded as
“classified loans”.
In Dec.94, the MA adopted as an industry guideline the Basel recommendation on risk management of derivatives, which focuses on high level controls by board
and senior management. A specialised team has been formed to examine the derivatives and trading activities of institutions which are active in this business, as
well as the adequacy of their risk management systems. In Mar.96, a more detailed operational guideline on financial derivatives was issued which drew on,
among other things, observations from internal control reviews, treasury visits to AIs, and the lessons from the Barings and Daiwa Bank incidents.

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HKMA Loan Classification System
Category Definition
Pass Loans where borrowers are
current in meeting
commitments & full
repayment of interest &
principal is not in doubt.
SM Loans where borrowers are
experiencing difficulties
which may threaten the
institution's position.
Ultimate loss is not
expected at this stage but
could occur if adverse
conditions persist.
SS Loans where borrowers are
displaying a definable
weakness that is likely to
jeopardise repayment.
Includes loans where some
loss of principal or interest
is possible after taking
account of the "net
realisable value" of
security, & rescheduled
loans where concessions
have been made to the
customer on interest or
principal (i.e. which have
been made on non-
commercial terms). N.B.
Such loans may be
upgraded to pass once they
have been serviced
according to the revised
terms for 6 months
(monthly repayments) / 12
months (other than
monthly repayments).
Typical Overdue Period *
Unsecured or partially-secured : Up to 3
months [N.B. downgrading to
substandard may be justified, even if
the loan has not been overdue for more
than 3 months, where other significant
deficiencies are present which threaten
the borrower's business, cash flow &
payment capability.]
Fully secured : Up to 12 months [N.B.
fully secured loans need not be
downgraded to substandard until they
are over 12 months overdue]
Unsecured or partially-secured :
Generally more than 3 months up to 6
months [N.B. downgrading to doubtful
may be justified, even if the loan has
not been overdue for more than 6
months, where other significant
deficiencies are present which threaten
the borrower's business, cash flow &
payment capability.]
Fully secured : Over 12 months
Provisioning
A general provision of at least 1% across-
the-board should be established.
Alternatively, the provision may be
calculated according to a formula based
on past loan loss experience in respect of
different categories of loans (e,g. ½% on
residential mortgages, 2% on taxi loans,
etc.).
No specific provision is necessary against
loans classified as special mention, but it
may be appropriate to increase the general
provision against such loans to, say, 2%
(whether secured or unsecured). For taxi
loans a specific provision of 2% on top of
a general provision of 2% is
recommended.
Specific provisions should normally be
made as soon as a loan is classified as
substandard, unless there are good
reasons to the contrary (however,
provisions against substandard loans may
not be necessary where the policy of the
AI is to classify loans promptly as
doubtful & to provision accordingly).
Provisions should be determined on a
loan-by-loan basis, with full provision
being made for the likely loss (i.e. the
irrecoverable amount). However, in
practice it may be difficult to reliably
estimate the likely loss (particularly at the
comparatively early stage of a loan being
downgraded to substandard). Generally
speaking, therefore, the level of
provisions in respect of individual loans
tends to be related to the loan
classification.
In the case of substandard loans, an AI
may typically provide 20-25% against the
unsecured portion of those loans that it is
unable to assess on a loan-by-loan basis.
In the case of portfolios of loans with
similar characteristics (e.g. credit cards)
the provision may be based on past loan
loss experience.
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D Loans where collection in
full is improbable & the
institution expects to
sustain a loss of principal
&/or interest after taking
account of the net relisable
value of security.
Unsecured or partially-secured :
Generally more than 6 months
Given that, generally speaking, the level
of provisions in respect of individual
loans tends to be related to the loan
classification, higher provisions will
generally be required when loans are
downgraded into a lower category (e.g.
from substandard to doubtful).

Typically, loans will be reclassified from

substandard to doubtful when the overdue
period increases to more than 6 months.
With this passage of time the position of
the borrower & therefore the position as
regards the degree of recoverability of the
loan may become clearer, & it may be
possible to more accurately assess the
likely loss on a loan-by-loan basis.
Consequently a range of provisioning
levels is possible. Typically, however,
provisions are likely to be in the range of
50-75% against the unsecured portion.
Provisions at the higher end of this range
(& perhaps as high as 100%) may be
appropriate where there has been no sign
of progress/improvement over time (e.g.
further provision should be considered
against loans which show no
improvement from one review period to
the next).

If it is still not possible to reliably

estimate the likely loss on some loans, it
is prudent for an AI to provide at least
50% against those doubtful loans that it is
unable to assess on a loan-by-loan basis.

L Loans which are All outstanding principal & interest which

considered uncollectible are not covered by the value of collateral
after exhausting all should be fully provided for or written off
collection efforts such as (e.g. 100% provision)
realisation of collateral,
institution of legal
proceedings, etc.

* In the case of loans under restructuring, the overdue period should be measured from the time the loan first went overdue
[no "grace period' should be given because the loan is under restructuring]

Interest accrual
Interest should be placed in suspense or cease to be accrued in respect of (1) loans where there is reasonable doubt about the
ultimate collectibility of principal &/or interest (irrespective of whether the contractual terms of the loan have been breached
or if the period of arrears is not more than 3 months); (2) loans on which contractual repayments of principal &/or interest are
more than 3 months in arrears & the net realizable value of security is insufficient to cover the payment of principal &
accrued interest, & (3) loans on which principal &/or interest is more than 12 months in arrears, irrespective of the net
realizable value of collateral.

Licensed banks are the only institutions permitted to carry on banking business in Hong Kong. This term is often used
interchangeably with bank.
A restricted licence bank may take time, call or notice deposits from members of the public in amounts of HK$500,000 and
above without restriction on maturity. Restricted licence banks generally engage in activities such as merchant banking and
capital market operations.
Deposit-taking companies are restricted to taking deposits of HK$100,000 or more with an original term to maturity of at
least three months. These companies are mostly owned by, or otherwise associated with, banks. They engage in a range of
specialised activities, including consumer finance, trade finance and securities business.