(Reprinted from HKCER Letters, Vol. 4, September 1990)
Alternative Approaches to Banking in Hong Kong
Two significant aspects of the legal and institutional banking arrangements in Hong Kong -- the Interest Rate Agreement and the holding of inner reserves -- will first be evaluated. An alternative approach of mutual fund banking will then be considered, along with the difficulties of the evolution of such an alternative under the present regulatory framework of the banking system in Hong Kong.
Losses due to the Interest Rate Agreement
Born in the heat of the banking crises of the early 1960s to eliminate "cut-throat" interest rate competition, the Interest Rate Agreement (IRA) costs customers billions of Hong Kong dollars each year and does not promote the stability of the banking system. It has not prevented banking crises since its creation in 1964, and there is little evidence that such competition caused troubles before. Under the IRA, current accounts do not earn interest. Savings rates and many types of time deposit rates are also kept below market levels. The loss of interest on the roughly HK$50 billion in current accounts, which conservatively might earn 5 percent if deregulated, alone is HK$2.5 billion per year. Approximating that the spread between the rate on the HK$130 billion in savings deposits received under the IRA and under competition is 2 percent, the savings depositors of Hong Kong forego HK$2.6 billion interest per year. If we assume that 10 percent of the HK$180 billion time deposits are covered by the IRA, and that again the IRA holds the return roughly 2 percent below competitive levels, then the annual loss for time depositors is HK$0.36 billion. By these admittedly rough estimates, total losses by Hong Kong depositors then exceed HK$5 billion per year.
Inner Reserves and Accounting Disclosure
The balance sheets and profit figures reported by the banks in Hong Kong do not reflect the true state of affairs. Banks hold a secret "inner" reserve into which they transfer profits in good years and draw down in bad years. While this provides bank managers with the discretion to reduce year-to-year fluctuations in reported results, it creates much uncertainty. Withholding such important information from the public exacerbates the potential instabilities of a fractional reserve system. If one person notices that other people are queuing to withdraw deposits, he might join the queue, even if he has no adverse information about the bank. Individuals act this way because they do not know the reserve position of the bank and they know that depositors at the end of the queue may not receive their money. The credibility of "secret" reserves will be strained, particularly as 1997 approaches. Revelation of the actual soundness of banks will allay fears and avoid potentially awkward confrontations between the new Banking Commission after 1997 and the banks.
In addition, allowing managers too much discretion could lead to unwise investments or to strategies that come to light only when the problem becomes great. In the U.S. in 1982, for example, an Act of Congress relaxed accounting standards for savings and loan institutions along the lines of inner reserve accounting. The result was poor management decisions and delays in addressing fundamental asset problems which have grown to crisis proportions.
Mutual Fund Banking: An Alternative Approach
The alternative approach to issues of stability and disclosure that we are considering here is the money market mutual fund account, operating as a unit trust. In this section we consider the features of such accounts and their effect on the banking system. In the subsequent section, we will examine specific barriers in Hong Kong to permitting such an alternative to compete effectively with the existing arrangements.
Information about the underlying value of the portfolio would be available much more frequently and fully than for a bank's portfolio, for two reasons. First, the assets would be quite liquid and frequently traded, thus generating a publicly observed price, unlike long-term loans and other illiquid holdings typically found on a bank's balance sheet. Second, the shares themselves would be priced, taking into account the information on the value of the underlying assets. In this way, the shares would be "marked to market."
Such a scheme, however, requires that the shares be subject to fluctuation in price, in sharp contrast to traditional bank accounts. These fluctuations can be made quite low by holding short-term, high-quality instruments in the fund(the short- term nature minimizes interest-raterisk, and top-quality nature minimizes bankruptcy risk). In the more than 15-year history of money market mutual funds in the United States, which now holds over US$300 billion, shareholders have experienced no capital losses. (Through swap-account-type arrangements, given the link to the U.S. dollar, U.S. Treasury paper could be held in the funds of the most risk-averse.) Certainly, depositors willing to trade off greater risk of changes in capital value for increased return may do so by choosing a more aggressive unit trust.
The structure of unit trust accounts, in contrast to bank accounts, can insulate the financial system from panic runs. There are no information asymmetries since the assets are frequently and publicly traded and priced. There is no credibility problem since there is no hidden reserve. There will be no incentive to try to get one's money out early, as there is under a fractional reserve bank. These favorable properties of money market mutual funds may be illustrated through an analogy between a bank run and an expected exchange rate devaluation.
Consider the exchange rate between deposits and currency. In normal times, of course, it is one-to-one. If there are problems at a bank and a run is expected, people fear that the one-to-one exchange rate may not hold -- that is, a run may force the bank to close its doors and pay off at less than one dollar (or, similarly, delay redemption, thereby rendering the value of a deposit dollar today less than a currency dollar today). The concern about a prospective "devaluation" leads people to try to get out of deposits and into cash. Even if a depositor does not believe that there is any problem with the underlying assets of the bank, withdrawals by others may lead him to withdraw also -- that is, the fears of a run may become self-fulfilling in this "me first" pay-out system of fractional reserve banks.
In contrast, there is no similar route for a self-fulfilling run at a mutual fund. Any "prospective" reduction in valuation reflects in the current prices of the units. In addition, a shareholder will not withdraw if he simply sees others doing so. He is not left "holding the bag" after the assets of a fractional reserve bank have been wiped out. On the contrary, he has a claim to an asset portfolio whose market value can be readily ascertained, and expectations about the value of the assets will appear in prices.
While it may appear at first that the demand for stable nominal value of deposit accounts is so great that it would not be feasible to offer an alternative, it must be remembered that in a fractional reserve system during "crisis" times, a dollar in a bank deposit may not be worth a dollar. That is, a bank may fail or may become illiquid and delay redemption. Thus, individuals are faced with a general trade-off: Accept some mild everyday capital value fluctuation and receive market rates of interest, or receive below market rates of return in order to have stable nominal value deposits except in "crisis" times. The risk properties of money market mutual funds are therefore much more like standard insurance contracts than deposits at banks: People are willing to accept a small deductible (everyday capital value fluctuation) in order to insure against the major losses (as in a banking crisis).
The expansion of money market funds also would have consequences for the development of the Hong Kong money market. The growth of money market funds would add liquidity to the Hong Kong money markets. This growth will encourage financial innovations including repackaging and securitization of otherwise illiquid assets. With the inflow of more funds, the money markets would become more attractive to potential issuers. Naturally, as has occurred in the United States, corporations may substitute money market issues of commercial paper for bank loans. Thus, the development of the Hong Kong money markets, which the introduction of money market accounts fosters, would provide competition to banks on both the asset side (for loans) and the liability side (for deposits) of the balance sheet.
There are a number of obstacles to the evolution of mutual fund-type banking arrangements in Hong Kong. First, the Securities and Futures Commission requires that these accounts have a HK$50,000 minimum. Smaller, retail depositors thereby are excluded from this market. Second, restrictions on the contents of offering documents and advertising material impede the flow of information to potential customers about the benefits of money market funds. The third, and most fundamental obstacle, is that money market mutual funds are denied access to the check- clearing mechanism. The monopoly clearing house, which is run by the Hong Kong Association of Banks, will accept only those adhering to rules of the Association, e.g., the IRA; thus, money market mutual funds cannot compete with the services of current accounts.
The banking system of Hong Kong would be strengthened greatly by the elimination of the Interest Rate Agreement and by an increase in public disclosure, in particular, disclosures revealing the inner reserves. This strengthening would be accompanied by a large improvement in the welfare of depositors as they enjoy higher rates of return, feel more confident in the reserve position of the banks, and enjoy important financial innovations. The widespread adoption of money market accounts that could come with the end of the IRA and a relaxation of restrictions on their use could provide depositors with significantly improved returns, foster the growth of the money market -- which in turn may lower the cost of capital to enterprises -- and improve the overall stability of the banking system by reducing the susceptibility to "panic" runs.
Professor Randall Kroszner teaches at the Graduate School of Business at the University of Chicago.