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					           Fin 3030
          Hugh Thomas

Lecture 1: The Nature of Banking
             January 2009
 Hong Kong is an International
      Financial Center
• Hong Kong Provides wholesale banking
     • Wholesale retail division unclear
     • I usually means transactions > 1 million (FX
       market smallest transaction)
     • could be as low as US10,000 (T-bond size) or
       HK$100,000 (HK deposits insurance in 06)
• Critical mass of experienced financial
       HK is a Regional Center
• financial world is tri-polar. There are 3 primary
  global centers
      • London
      • New York
      • Tokyo
• HK is a secondary center
   – competitive advantages over regional rivals
      • Better heritage, expertise, free markets and legal system than
      • Better size, regional stability and links with China than
      • Tokyo, the East Asian Global Center, is a less international
        with poor English skills
 Financial Institutions are Important
            to Hong Kong
• FIs provide essential services to the local
• FIs Provide employment and income from
  exporting financial services
• 80 of largest 100 banks in the world are in
Table 1: The Importance of Banking and Finance to Hong Kong

Item                                                Hong         USA
Balance on Services/GDP (%)                     11%                        1%
Labor Force in Finance (%)*                     14%                        5%
Stock Market Capitalization to GDP                3.7                       1.8
Stock Market Capitalization in Finance (%)      29%                       18%
Annual Clearing House Turnover per         1,854,243                 1,503,073
capita (US$)
Population per Deposit Taking financial       27,092                     29,335
Population per branch                          4,533                     3,936
Banking Assets Per Capita (US$)**          $116,026                    $27,901
Banking Assets/GDP (ratio) **                   5.21                      0.80
* Includes banking, insurance and real estate and other business services.
** Includes all deposit taking companies
Sources: HKMA, Hong Kong Financial Services Bureau, US Department of Commerce, US Federal
Deposit Insurance Corporation, US Federal Reserve, OECD
 Problems with Measures in Table 1

• Balance on services includes tourism
  (deficit) and non-financial business services
  (eg, accounting, management, consulting,
• Finance in labor force includes real estate
• stock market is majority china plays
• Payments includes only HK clearings
       Banking is Important in China but
       Development of Banking is Recent
• 1984 Designation of PBOC as Central Bank
• Late 1980s Stock Banks established
• 1994 Separation of policy banks from commercial banks
• 1995 Commercial Banking Law adopted
• 1995 RMB270 billion equity injection
• 1999 Asset Management Companies established
• 2003 China Banking Regulatory Commission established
• 2004 Banking Supervision and Regulation Law
• 2003 – 2005 Huijian contributes to recapitalize CCB, BOC and
• 2001-2006 national and international listings of banks
• 2007 CITIC investments invests in Bear Sterns (US$1 b); China
  Investment Corp buys into Blackstone & Morgan Stanley
But What Is a Bank?
              An Exercise –
          Spot the 6 Differences
Refer to specific line items in the HSBC
  Consolidated Profit and Loss Account and
  Consolidated Balance Sheet on pages 207-208 of
  the HSBC 2008 Interim Report. Identify six line
  items in the HSBC financial statements that differ
  from similar line items (if any) of non-financial
  corporations. State how they differ and how the
  differences reflect how bank differ from a non-
  financial corporations.
Six Differences between banks and nonFIs
  • Largest liability category is deposits, which form society’s money.
    Non-FIs are not allowed to take deposits (i.e. short term borrowings
    solicited from the general public)
  • Banks have deposits with the central bank (i.e., high power money)
    which form the medium of exchange at the center of the payment
  • HSBC’s, BOC and SCB liabilities include notes in circulation backed
    by an equal amount of certificates of indebtedness (US$ deposits with
    the EF)
  • Banks have very high leverage (HSBC D:E approximately 18:1)
    compared to non FIs
  • The major assets of banks are fixed income assets (i.e., loans, bonds,
    bills and notes). For non FIs, the major assets are trade receivables,
    physical inventories and fixed plant and equipment
  • The major income of banks is net interest income versus sales of
    products or non-financial services for non FIs
     More than six differences …
• Because banks have such a high proportion of fixed income assets,
  provisions for credit losses are a far larger item in the income
  statements than in non FIs
• Banks place wholesale deposits with other banks (assets) and taking
  deposits from banks (liabilities). While other companies do this banks
  like HSBC are market makers in the interbank market placing
  continuous bids to buy and offers to sell wholesale deposits.
• Banks show items in the process of collection as separate items
  because they represent a higher proportion of assets and liabilities than
  for non FIs
• Banks are market makers in financial markets so dealing profits is a
  larger source of profits than for non-FIs
• Banks contingencies (guarantees, acceptances, derivatives) form a far
  higher proportion of their assets than non-FIs; Banks derivatives
  portfolios are large, such that marked to market value of in-the-money
  derivatives (assets) and out-of-the money derivatives (liabilities) are
  large relative to total assets (HSBC 10%.
 Banking is an Intermediated Financial
• I. Intermediated – the investor invests in the FI and the FI invests in
  the investee
   – Banks and other deposit taking companies (AIs) are the main
      intermediated FI
   – finance companies
   – insurance companies (not covered in this course)
• II. Disintermediated – the investor is helped by the FI but investor
  invests directly in securities
   – markets serviced by banks and investment banks
   – Banks, investment banks and other FIs serve as market makers,
      asset managers, advisors and information producers and processors
   The Banking Ordinance Defines
        Banks in Hong Kong
           Chapter 155
• Read BLISS (Bilingual Laws Information
  System )
• Banking Ordinance is implemented by Hong
  Kong Monetary Authority
• defines “banking business” as taking deposits or
  making payments
 HK’s Legal Definition of Banking
“banking” usually means the business of
 either or both of the following --
  (a) receiving from the general public money on
    current, deposit, savings or other similar
    account repayable on demand or within a
    relatively short specified time (eg., less than 3
  (b) paying or collecting cheques drawn on or paid
    in by customers.

       But banks do far more than just “banking”
          Banks in Hong Kong are institutions
             authorized by the Hong Kong
           Monetary Authority or Authorized
                  Institutions (“AIs”)
                                                     Banks            RLBs             DTCs
Minimum Deposit Amount                               No restriction   HK$500,000       HK$100,000
Minimum Deposit Maturity                             No restriction   No Restriction   3 months
Minimum Share Capital of AI incorporated in   Hong   150 million      100 million      25 million
Minimum Assets of AI incorporated outside of HK      US$16 billion    Na               Na
Minimum deposits of AI incorporated in Hong Kong     HK$3 billion     Na               Na
Minimum assets of AI incorporate in Hong Kong        HK$ 4 billion    Na               Na
Maximum Basel Capital Adequacy Ratio to be           12%              16%              16%
     Other FI Regulators in HK
• Insurance activities
  – Commissioner of Insurance.
• Public securities
  – Securities and Futures Commission
  – Hong Kong Exchange
• Pension funds
  – Mandatory Provident Fund Authority
Service                        Retail                        Wholesale

Payments                       ATMs, check clearing,         Real time gross settlement
                               phone banking
                                                              Large corporate and
Deposit Taking                 Checking & savings A/C

Lending                        Credit cards, mortgages Large corporate and
                               SME loans               governments
Asset Management               Fund sales, custody           Fund management, pension
                                                             management, custody
Market Making                  Retail brokerage              OTC trading, exchange
                                                             member trading,
Underwriting and placing       Retail Distribution           Stocks, bonds, securitization
of securities
Advising                       Financial planning,           Merger and Acquisition advising

Insurance                      Life, property, casualty      Large event risk, reinsurance

                        Decreasing Need for Regulatory Oversight

Note:       Darker Shaded Areas Denote       Lighter shaded area denotes traditional but
            Defined Banking services         not defined banking services
               Number of AIs in Hong Kong
                        Licensed banks             Restricted licence banks Deposit-taking companies
                         持牌銀行                        有限制牌照銀行                     接受存款公司

                    Incor-      Incor-            Incor-          Incor-                                All
                   porated     porated           porated         porated                        authorized

       • (AIs)
As at end of
                    in HK  outside HK
                 在香港註冊 在香港境外註冊
                                                  in HK
                                                             outside HK
                                                                                             所有認可機構 本港

1993    Dec            32                140         33                 24            139              371
1994    Dec            32                148         35                 28            134              380
1995    Dec            31                154          37                 26            129             380
1996    Dec            31                151          38                 24            121             368
1997    Dec            31                149          39                 27            113             361
1998    Dec            31                141          35                 25             99             333
1999    Dec            31                125          33                 25             71             285
2000    Dec            31                123       Why the 46% Drop?
                                                    28        20                        61             263
2001    Dec            29                118          29                 20             54             250
2002    Dec            26                107         28                 18             45              224
2003    Dec            23                111          26                 16             39             215
2004    Dec            24                109          25                 15             35             208
2005    Dec            24                109          20                 13             33             199
2006    Dec            24                114          18                 13             33             202
2007    Dec            23                119          16                 13             29             200
2008    Nov            23                122          16                 12             29             202
AIs’ numbers have dropped because

• Domestic Bank Consolidation
• Foreign Bank Consolidation
• Foreign Banking Deregulation that lowers
  regulatory arbitrage
• HK banking deregulation that lowers
  relative advantage of DTCs and RLBs
  lowering need for multiple licenses.
HK AIs Dec 2007 (in billions of HK dollars)
  Assets                                                     HK$ 港元 FC 外幣Total 總計
  Notes and coins                           紙幣及硬幣                17       4       21
  Amount due from authorized institutions   香港銀行同業貸款            371     294      664
  Amount due from banks abroad              境外銀行同業貸款            501    3,448    3,949
  Loans and advances to customers           客戶貸款及墊款            2,236    824     3,060
  Negotiable certificates of deposit held :     可轉讓存款證:          65       29       95
  Negotiable debt instruments held, other than NCDs:            506    1,160    1,665
    of which Government Bonds Bills and Notes        政府票據及債券    260      75      335
  Investments in shareholdings              參股投資                 81      44      125
  Interests in land and buildings           土地及房屋權益              69       0       69
  Other assets                              其他資產                304     653      957
  Total assets                              資產總額               4,150   6,456   10,606
  Liabilities                               負債
  Amount due to authorized institutions     香港銀行同業借款            378     299      677
  Amount due to banks abroad                境外銀行同業借款            265    2,215    2,480
  Deposits from customers                   客戶存款               3,020   2,756    5,776
  Negotiable certificates of deposit outstanding 未償還可轉讓存款證      119      47      166
  Other debt instruments outstanding        未償還其他債務工具            16      98      114
  Capital, reserves and other liabilities   資本、儲備及其他負債          812     581     1,393
  Total liabilities                         負債總額               4,610   5,996   10,606
     “US” Balance Sheet Assets
              (probanker presentation in thousands)
                    The Federal Reserve)
Required Reserves (at theUS Central Bank            30,637.57
Excess Reserve Balances (at other commercial
banks)                                                   0.00
Federal Funds Sold      Interbank Deposits Placed        0.00
Fixed Rate Corporate Loans                         152,071.48
Floating Rate Corporate Loans                      435,717.25
Installment Loans                                  350,612.88
Mortgages                                          425,548.94
Bonds                                              180,000.00
Fixed Assets                                        21,739.00
Loan Loss Allowance Actually liability “reserve”     5,300.25
Total Assets                                     1,596,327.10
     “US” Balance Sheet Summary -
If you lend to a company, you know you own a debt …
     Federal Funds Purchased
        Interbank Deposits Taken                               35,000.00
     Retail Demand Deposits                                   159,355.67
     Corporate Demand Deposits                                147,020.03
     Negotiable CDs
      Certificates of Deposits that are public securities     200,000.00
     Passbook Deposits                                         86,714.41
     Retail CDs                                               326,304.90
      Investment Retirement Accounts (like MPFs)              327,278.40
     Discount Window Advances                                 191,752.84
     Net Worth and Retained Earnings                          117,600.59
                                  … NET lend to
     TOTAL LIABILITIES ANDIf youWORTH            a bank     1,596,327.10
                                 You think you have “money in the bank”
  Money: is the core of banking
• most liquid medium of exchange
• Any commodity can be used by society
      gold and silver bullion
      metal coins
      deposit receipts for precious metals
     •   commercial drafts accepted for payment by the drawee
     •   drafts accepted by banks
     •   bank notes (paper currency issued by banks)
        Government-issued paper currency
   deposits of commercial banks and other deposit taking
    FIs are the major form of money in today’s modern
When people lend, in general they
  feel they have made a loan.

When they lend to a bank, in general
 they feel they have “money in the

 A bank’s short term liabilities are
 considered to be society’s money.
              high power money vs
                the money supply
• high power money: obligation of Central Bank /
  Treasury (the monetary base)
   – Notes of treasury, banknotes, coins and clearing balances
   – potential high power money includes central bank / treasury
     notes and bills that can be repo-ed
• Banking System Money Supply
   – deposits legal obligation of banks
   – backed by assets: loans

    Bank and other Deposit-Taking
       FI Deposits are Money
            yet they are backed largely by loans
A HK Bank Uses Its Account with the
  Exchange Fund to Make Payment
• To make payment bank needs a positive clearing
  balance with the Exchange Fund of at least the
  payment amount
• Can obtain clearing balances by
   – buy with US dollars in the foreign exchange market
   – borrow clearing balances from the Exchange Fund
     using Discount Window Sale and Repurchase
     Agreements or repos
   – borrow from other banks in the Hong Kong interbank
     market at the Hong Kong Interbank Offer Rate
Table 7: Hong Kong’s Hong Kong Dollar                Clearing and Settlement System
Name of                    Securities clearing       Electronic Debit             Clearing House
Component                  and settlement            System (EDS)                 Automated Transfer
                           System                                                 System (CHATS)
Input                      Paper                     Retail Electronic            Wholesale Electronic
Types of Transactions      Checks, drafts, bills     autopay, electronic          Foreign exchange,
                                                     clearing items generated     payment for securities,
                                                     by the securities clearing   banks obtaining clearing
                                                     and settlement system,       balances
                                                     point-of-sale clearing
                                                     and settlement system
Frequency of Clearing      Daily batch               Daily batch                  Continuous
Reporting of balances to   Daily                     Daily                        Real time
Timing of Settlement       Next day                  Next Day                     Simultaneous
relative to processing
Effect on balance with     Net payments debited or   Net payments debited or      Gross payments debited
Exchange Fund              credited                  credited                     or credited
Percent of Transactions    6%                        6%                           88%
by Value
              Banks Provide

•   Liquidity
•   Credit Monitoring abilities
•   Diversification and Asset Transformation
•   Financial Information
•   Servicing debt, equities and derivatives
… and enjoy strong economies of
scale from systems and reputation
•   Payments
•   Deposit taking
•   Custody
•   Credit information sharing
•   Market making
   Banks are regulated because
 interruption of banking services
is contagious and so constitutes a
           systemic risk
•   Destroy money              These two risks
•   Disrupt Payment services   are by far
                               the most important
•   Shrink Credit
•   Inhibit Risk off-lay
•   Retard information flow

In Hong Kong the regulator is the HKMA
             Banks Face Risks
•   Liquidity
•   Interest Rate
•   Market
•   Credit
•   Operating
    Risk Affects the Value of a
      Bank’s Equity Capital
• Depositors, insurance claimants and other
  liability holders look to equity to cushion
  their claims against risk
• Equity holders wish to provide the
  minimum amount of capital to achieve the
  maximum profits
                                  Will the assumptions in the                   catastrophe /
  Interest Rates               risk pricing approximate reality ?                  Perils
                               Actuarial and Other Model Risk
                               Will environment changes adversely                Mortality /
 Foreign Exchange                      affect market price?                      morbidity
                                           Market Risk
    Commodity                       Will claims be disposable at            Product and service
      Prices                  Fair market price in event funding need?            Prices
         Economic                          Liquidity Risk
               Obligations (on and off BS)                    Obligations (on and off BS)

  Clients/                                      FI                            Clients/
Counterparties                                                              Counterparties
        Will                                                         Will FI operate
        Counterparty                                                 as anticipated?
        Meet                                                         Operating Risk
        Obligations?                                                 •technology
        Credit Risk                                                  •legal
 Optimal Debt ratio for FI is high
       relative to non-FIs
• Tax benefits to borrowing
• Fixed income assets dominate portfolio
   – Fixed income assets are nearly riskless (so loss in
     liquidation is low relative to other assets)
• High degree of government supervision inspires
  debt-holders' confidence
   – Confidence is so high that debt holders think they have
     “money in the bank”
• Belief in the implicit guarantee of banks over bank
  liabilities creates conditions for moral hazard
     The Role of Bank Capital
• Provides controlling source of funds
  – riskiest funds need attractive rate of return
  – equity shareholders elect board of directors
  – management makes capital structure decision
• Provides a cushion
  – protects firm’s solvency
     • reduces distress costs
     • value in operations versus value in liquidation
  – inspires debt-holders' confidence
  – protects uninsured depositors
  – safeguards financial system from systemic risk
  To Avoid Moral Hazard, Banks are
         Highly Regulated
• capital adequacy requirements most
  important (Basel Accord)
• Hong Kong also regulates banks through
     • liquidity requirements (Hong Kong has a statutory
       liquidity requirement)
     • liability guarantee funds (Hong Kong’s deposit
       insurance was passed in 2004 and implemented in
     • regular monitoring – risk based assessment of
        – Capital, Assets, Management, Efficiency and Liqidity

• Restriction of entry

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