The Supervisory Answer to Hong Kong’s Worsening Economic Performance

Pierre Latrobe at Mazars discusses the measures the HKMA has taken so far to strengthen its macroprudential supervisory toolkit and address potential risks to the wider financial system.

The Hong Kong economy is suffering from several lingering negative factors, the US-China trade war, the global economic slowdown and the ongoing protests, to name but a few. As a consequence, the year-on-year GDP growth rate decreased to 0.6% in the first quarter of 2019 and reached a ten-year low of 0.5% in the second quarter.

The Hong Kong Government revised downwards its full-year growth forecast for 2019 to a range of 0%-1% from the previous 2%-3%. To make things worse, both Fitch and Moody’s downgraded Hong Kong’s outlook to negative in September, arguing that the attractiveness of Hong Kong as a trade and financial hub has been damaged.

For now, the good health of the Hong Kong banking sector enables it to withstand the stressed market conditions. The consolidated Tier 1 capital ratio of locally incorporated authorised institutions amounted to 18.2% in the first half of 2019, well above the minimum international standards. Although the average liquidity coverage ratio decreased to 152.8% as of June 2019 from 167.3% as of December 2018, this remains above the statutory requirements of 100%.

Yet, the HKMA (Hong Kong Monetary Authority) has taken several measures recently to strengthen its macroprudential supervisory toolkit, address potential risks to the wider financial system, and ensure businesses are able to continue accessing credit.

Restating the existing framework for provision of liquidity and creating the Resolution Facility

The Liquidity Facilities Framework through which the HKMA makes temporary HKD liquidity available to banks under its supervision was updated in July 2019. The HKMA restated the existing framework to enhance the existing liquidity arrangements, namely the Settlement Facilities for the interbank payment system, the Standby Liquidity Facilities for short-term funding for up to a month, and the Contingent Term Facility for a bank facing extraordinary liquidity stress that it is unable to resolve through other means.

In addition to the existing facilities, a Resolution Facility was introduced. It follows the implementation of the Financial Institutions Resolution Ordinance (FIRO) in July 2017 which aims at managing a bank’s failure in an orderly way and redirecting the costs of failure from taxpayers to certain creditors and shareholders of the non-viable bank. This new facility is designed to ensure that a bank which has gone into resolution in Hong Kong has sufficient liquidity to meet its obligations, until such time as it is able to transition back to market-based funding.

Although the framework was already under development and not prompted specifically by the current economic situation, it is suggested the turmoil may have hastened its introduction.

Adjusting the countercyclical capital buffer

Despite the low interest environment in 2018, businesses started to shy away from borrowing money to invest, as shown by credit lending growth which decreased from 16.1% in 2017 to 4.4% last year, including a -0.9% contraction in the second half of 2018. For the first half of 2019, the trend slightly reversed with a moderate credit growth of 4.2% supported by domestic corporate loans and household personal loans to private banking and wealth management customers.

In order to ease credit lending and foster economic growth in Hong Kong, the HKMA announced on 14 October that the CCyB (countercyclical capital buffer) for Hong Kong is reduced to 2.0 per cent from 2.5 percent with immediate effect, although the 2019 Q2 data would have suggested a CCyB of 2.25 percent. As a matter of fact, the HKMA indicated in its announcement that “the economic environment in Hong Kong has deteriorated significantly since June 2019.”

It is worth noting that this first reduction in the CCyB since 2015 is expecting to release an additional HKD 200-300 billion of bank credit.

Establishing a banking sector SME lending coordination mechanism

The first businesses to be impacted during stressed market conditions are traditionally SMEs as they are less defensive. One of the primary measures taken by the Hong Kong Government at the beginning of the US-China trade dispute was to enhance support from the “Dedicated Fund on Branding, Upgrading and Domestic Sales” (the BUD Fund) to Hong Kong enterprises. The BUD Fund support, initially designed to cover Mainland China, was extended to the ASEAN markets in August 2018 to facilitate exploring new markets and avoid over-reliance on the Mainland.

In the same vein, the HKMA recently established a banking sector SME lending coordination mechanism to strengthen funding support for SMEs. The mechanism aims to alleviate pressure on SME cash flows, as far as the credit and risk management policies of banks allow. So far, nine major banks – HSBC, Standard Chartered, BOCHK, Citibank, Hang Seng Bank, Bank of East Asia, DBS, ICBC Asia and CCB Asia – have been consulted to provide funding support to SMEs within this mechanism.

As it is in all interests that a business should survive if there is a reasonable possibility that it may be viable, banks’ initial attitude should be one of support. This means that banks are expected to review arrangements for principal payment deferrals, loan extensions or other concessionary measures for SMEs facing financial difficulties. It also means banks should facilitate SMEs in opening bank accounts and support them in meeting financial needs arising from the restructuring of supply chains in response to the Sino-US trade war.

The HKMA indicated that revised financial terms may not trigger the reclassification of a loan in the category ‘rescheduled loan’, also called “forborne loan” in other jurisdictions. The new repayment terms should be regarded as “commercial” if it does not involve a reduction in principal repayment, and the applicable interest rates of the loan are not substantially below prevailing market levels. This approach introduces more room for judgment in respect of the classification of exposures between performing, non-performing and restructured loans. Indeed, there is always latitude on interpretations on whether a restructuring is a commercial one or is attributable to financial difficulties.

What to expect in the near term?

There is a delicate trade-off to achieve since unleashing funding support may impose downward pressure on banks’ profitability in the near term and undermine the credit quality reported by banks.

With regard to the profitability, Hong Kong’s banking sector posted a modest 0.6% year-on-year growth of the aggregate pre-tax operating profit of retail banks in the first half of 2019. The growth in net interest income was offset by a shrinking non-interest income and higher impairment charges and operating expenses.

Credit quality slightly deteriorated in the first half of 2019, as reflected by the gross classified loan ratio which includes loan classified as “sub-standard”, “doubtful” and “loss”. The ratio edged up to 0.54% as of June 2019 for retail banks, compared with 0.50% as of December 2018.

It is worth noting that the property development and the property investment sectors accounted for most of the impairment charge increases. Indeed, the value of overall property transactions slumped 14.3% month-on-month to HKD 36.38 billion in September, the lowest since July 2016, according to Midland Realty.

One thing, for sure, is that both the efficiency of the supervisory measures to mitigate the economic cycle and the impacts on the banking sector performance will be under close scrutiny in the coming months.

Pierre Latrobe is Director of Financial Services at international professional services firm Mazars, and highly experienced in providing tailored solutions to supervisory authorities and international banks in respect of reviews of banking sector risks.

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