Chapter 19 Organization of Central Banks

Hong Kong Monetary Authority HKMA formed in 1993 with merger of Exchange Fund and Commissioner of Banking to perform role of the central bank. 1.Regulation of the Banking System 2.Operation of the System of Payments 3.Control of the Monetary Base

Payment Settlement System 1.Prior to 1988: Settlement occurs using accounts at Hong Kong Bank 2.Accounting Arrangements ( ): HSBC opens a clearing account at the HSBC with the amount controlled by HKMA. If net clearing accounts at HSBC exceed account of HSBC at HKMA, HSBC must pay interest to HKMA. 3.Hong Kong Dollar System (1996-Date) All banks hold clearing balances at the HKMA to settle interbank claims. [Real Time Gross Settlement System] 4.US Dollar Clearing System (2000) US Dollar chief currency of international financial system, but US Payment system shutdown during most of HK business day. HKMA operates US dollar payment system to encourage trade in US dollar securities in HK.

History of Hong Kong Monetary System 1841: 1862 Multiple currencies used in Hong Kong. 1863: 1935 – Silver Standard: Hong Kong banks issue dollar notes backed by silver bullion. 1935: 1972 – Sterling Standard: Hong Kong banks issue dollar notes backed by UK pounds. 1972: 1974 – Fixed Exchange Rate with US dollar 1974:1983 – Floating Exchange Rate 1984: Today - Linked Exchange Rate System

HKMA Organization Financial Secretary Exchange Fund Advisory Committee Chief Executive HKMA Research Monetary Policy External Relations Reserves Management Banking Policy & Regulation

Major Changes in Regulatory Regimes 1948 – The first bank ordinance allows the governor to reject applications for bank licenses Banking ordinance created Commissioner of Banking to regulate banks, required 25% liquidity ratio which is still in effect Interest Rate Agreement creates the Banking Cartel

Major Changes Pt DTC Ordinance Three Tier system formed 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 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. 1.All other depositors keep their funds in the bank and the bank survives. 2.All other depositors withdraw funds and the bank must liquidate. Payoffs 1.If an individual keeps their funds with the bank and everyone else does likewise, everyone gets their funds with interest. 2.If an individual doesn’t withdraw, but everyone else does, the bank will have nothing left to pay the individual who gets nothing. 3.If the individual depositor withdraws but no one else does, the depositor loses only interest. 4.If an individual depositor withdraws and everyone else does, they have some chance of getting some funds (say $500) back. Individual Depositors Decision All Other Depositors Decision WithdrawDon’t Withdraw Payoff: $500 Payoff: $0 Don’t Withdraw Payoff: $1000 Payoff: 1100

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.

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.

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 , 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 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

Property Market Collapse Leads to an Increase in NPL’s.

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.

Important Ratios Loan to Value Ratio – Banks cannot make mortgage loans greater than 70% of the value of apartments. Liquidity Ratio Capital Adequacy Ratio: Banks must have net worth equal to 8% of quantity of risk adjusted assets.

Capital Adequacy Ratio of HK Banks