Assessment of the interest rate rules Strengths

Interest rate stability

The IRR regulated rates are less responsive to volatile market conditions and provide a measure of price stability. For example:

Ø Over the period from October 1993 to August 1997, the IRR rates for savings accounts changed broadly in line with HIBOR rates. There has typically been an average spread of around 1.5% below overnight HIBOR from 1993 to 1997.

However, in the period from September 1997 to September 1998, although the IRR rates increased three times (in October 1997, January 1998 and March 1998), they have been considerably more stable that the volatile HIBOR rates.

Ø In the period since September 1997, the rate paid on savings accounts under the IRRs has increased from 4.00% to 5.25%, whereas the rate paid on 1-month HIBOR has fluctuated between 5.5% and 12.00%³⁹ (see Chart 1.8.3).

Similarly, the prime rate, which is in practice adjusted by the leading banks following a change in the IRR savings rate, has maintained a consistent spread of 4.75% over the IRR savings rate in the period from March 1994 to August 1997. During the Asian crisis, it has also been stable in comparison to the volatile HIBOR rates.

One consequence of the IRRs is that they act as a benchmark rate for banks to price their prime or best lending rates. In the absence of a government base rate which, in other countries (e.g. the US, the UK) provides this benchmark, banks will need to look to market interest rates (such as HIBOR) for a reference rate. It is questionable whether a more responsive market pricing mechanism for prime, benchmarked off HIBOR, would benefit the market (and Hong Kong in general) in view of the current instability of HIBOR. The fact remains that HIBOR pricing is driven by the market liquidity demand/supply curve which, in times of a shortage of Hong Kong dollars (whether due to pressures on the exchange rate or other reasons), can become extremely volatile (e.g.

overnight rates of up to 280% in October last year).

It should be noted that the rate stability provided by the IRRs has helped cushion falls in bank profitability and, in doing so, provided a measure of sector stability, especially in the light of the destabilising competition for time deposits during this period. In addition, the fact that the prime rate has not fluctuated wildly despite the volatility in market rates (see Chart 1.8.3), may have helped to soften the declines in the property market which is sensitive to interest rate changes. This stable interest rate environment can also contribute to lower default rates on mortgages and other property-related lending which comprise a substantial portion of banks’ loan portfolios.

39 Source: HKMA - period average figures

Competitive position of small banks

There is a significant concentration of IRR regulated deposits in the larger banks (the HSBC Group, the BOC Group and Standard Chartered Bank), which reflects their dominance in the market. The fact that smaller local banks do not have to compete for savings and current account deposits on a price-basis with these larger institutions goes some way to address their limited market share. Without this restriction on the larger banks (i.e. not to be able to compete on interest pricing) it is possible that they would be able to take advantage of their dominance and price the smaller players out of the market.

Weaknesses

The theoretical arguments against interest rate controls are well set out in American economic research prior to deregulation of these controls in the 1970s and 1980s⁴⁰. Essentially, banks will compete in different ways if they are impeded from competing on interest rate pricing. They will tend to offer alternative or modified services (e.g. no transaction charges or minimum balance requirements) or discounts on other financial products (e.g. lower lending rates) even though such arrangements may also be proscribed. In addition, consumers and the market will seek ways to circumvent such restrictions (e.g. swap deposits).

Consequently, the effect of interest rate controls is simply to redirect competition and cause efficient banks to divert resources into other activities or facilities that would otherwise be potentially paid to depositors. For example, they may open additional branches to collect more (relatively cheap) deposits. At the same time, the controls act as subsidies to inefficient institutions by lowering their cost of funds, thereby retaining

40 For example, Ben Klein “Competitive interest payments on bank deposits and the long-run demand for money” − American Economic Review December 1974.

Chart 4.9.3 Prime vs HIBOR vs IRR savings

0 2 4 6 8 10 12

Sep-93 Dec-93 Mar-94 Jun-94 Sep-94 Dec-94 Mar-95 Jun-95 Sep-95 Dec-95 Mar-96 Jun-96 Sep-96 Dec-96 Mar-97 Jun-97 Sep-97 Dec-97 Mar-98 Jun-98 Chart 1.8.3 Prime vs. HIBOR vs IRRs savings

Source: HKMA Monthly Statistical Bulletin Prime Average 1 month HIBOR IRR savings

more institutions in the industry than is optimal. Therefore, one consequence of deregulation will be that banks will reassess individual branch profitability and their existing branch network distribution. Deregulation may also bring forward the process of consolidation in the sector.

Additionally, it has been the experience of advanced financial economies that, in the long run, such regulations will prove to be too costly to be maintained or simply ineffective. For example, in the US, one of the driving forces for the deregulation of interest rate controls was the growth of money market funds that offered higher rates of return. The interest rate controls had therefore reduced banks’ competitiveness in attracting deposits.

Price competition

The IRRs directly restrict price competition on certain deposits and consumers therefore lose out in terms of interest received on these deposits. For example, the Consumer Council, in its report in 1994, estimated that the total monopsonistic⁴¹ rents extracted from HKAB depositors amounted to HK$5.17billion or 0.8% of GDP in 1991.

Resource allocation

Efficient allocation of capital resources is the primary role of banks in an economy (i.e.

intermediation). As banks are the dominant intermediaries in Hong Kong, interest rates become the primary mechanism for determining capital allocation in the local economy.

For example, as savings account interest rates do not vary between banks, savings are not channelled to those institutions which give the best return for the risk involved (i.e.

those banks that are more effective at managing their lending activities and business operations). A similar situation may also arise on the lending side, where the consistent spread of Prime over IRRs savings rates may encourage banks to concentrate their lending on Prime-based products such as mortgages.

Consumer choice

The specific restriction governing current accounts (i.e. no interest is allowed to be paid) has reduced the choice available to consumers in retail accounts in comparison to other international financial centres. For example, a variety of accounts such as high interest accounts with more stringent terms or low interest accounts with more transactional freedom could become available if banks were allowed to compete freely in this regard.

The principle argument for maintaining this distinction (i.e. interest bearing versus non-interest bearing) between the savings and current accounts appears to be that current accounts are transactional (i.e. customers are allowed to use cheques) and therefore, depositors receive transactional services rather than interest. This situation is changing rapidly due to technology and it is notable that in Hong Kong electronic payment items are transacted through savings accounts. For example, Payment-by-Phone Services, direct debits and standing orders are transactions, which would have been performed

41 The term monopsonistic is used, as opposed to monopolistic, because banks are perceived as buyers (as opposed to sellers) in the deposits market.

using cheques a few years ago, that can all be transacted through savings accounts.

Savings accounts are therefore developing as transactional accounts and the distinction between savings and current accounts is blurring.

This observation does not appear to support the argument that a distinction needs to be maintained between current accounts and savings accounts. Even if such a distinction were to be needed, it should be possible to operate a sweep account that automatically transfers funds to or from current accounts to match cheque payments or receipts.

However, such an arrangement is specifically prohibited by the IRRs⁴².

A further point to note is that a number of banks in Hong Kong pay interest on current accounts to their staff members (which they are allowed to do under the IRRs). This implies that, although there may be a need to keep the accounts separate for cheque clearing purposes, the systems are available to deal with this issue. This should not therefore prevent the payment of interest on these accounts, which in fact is allowed and occurs in other countries.

Consolidation

Smaller local banks are predominantly retail market orientated. Therefore, lower funding costs and protection of retail interest spreads may allow sub-scale banks to continue business by limiting the effectiveness of the competitive mechanism to weed out weak players. While the major barrier to the consolidation of smaller banks in Hong Kong appears to be diversified shareholdings or family ownership, the IRRs may also have been a contributing factor.

Formal pricing mechanism

There exists in Hong Kong a formal mechanism for the pricing of IRR governed accounts (i.e. HKAB). This may create a perception that a cartel-based system is appropriate for Hong Kong, which is at odds with the international reputation of Hong Kong as an open economy. Therefore, the IRRs could be criticised from the laissez faire point of view because they act as a hindrance to the free play of market forces.

This situation is not dissimilar in other countries with an open and competitive environment, where the pricing of most accounts will be set by a few price-setting banks and generally followed by the smaller banks. Hence, although the manner in which interest rates are set for most deposits and loans is not dissimilar to other countries in practice, the formalised manner in which certain rates are set may detract from Hong Kong’s reputation as a leading financial centre.

42 It is worth noting that a customer can with most banks operate such a sweep arrangement themselves (albeit not automatically) using most ATM account transfers capabilities.

Cross subsidies

As banks are restricted in their ability to compete on interest rates, they compete through other areas. One consequence of the IRRs is that there is cross-subsidisation between IRR accounts and other products and services, which benefits smaller depositors (i.e. there are few transaction charges or minimum balance requirements levied on current and savings accounts in Hong Kong) at the expense of larger depositors.

While these cross-subsidies may achieve a desirable social objective of providing low cost banking services to the general population, it is normally considered to be inefficient for the sector as a whole, as it prevents individual products from being properly priced. Additionally, there is a view that it is unfair to penalise one group of consumers at the expense of another group.

1.8.6 Comparison with other international financial centres

Although some countries⁴³ have, in the past, placed interest rate restrictions on their banking markets, as far as we are aware, no major international financial centre continues to do so. However, some countries still restrict the types of deposit instruments (e.g. current accounts) that are allowed to pay interest, rather than restricting the deposit interest rates. For example, in the US, current accounts of for profit entities⁴⁴ are not allowed to pay interest. This restriction is a remnant of the old Regulation Q and relates to the fact that any demand deposit carries a liquid reserve balance that must be maintained at the Federal Reserve Bank. As a consequence, most for profit entities maintain their balances in interest bearing accounts that will allow them to transfer funds as needed to their current accounts. (In fact, banks in the US perform a tremendous amount of cash management business).

1.8.7 Views of market participants

All types of authorized institutions were against eliminating the remaining IRRs within the next five years. The local banks were most strongly against any deregulation and, in particular, are almost totally against allowing interest to be charged on current accounts (see Table 1.8.5):

43 For example, the US, UK, Canada, Japan, Korea and New Zealand. Interest rates were deregulated in the US in 1980-86, UK and Canada in 1967 and 1971, Japan in 1993 and New Zealand in 1983.

44 For profit entities include any organisation that intends to generate income for the benefit of its stockholders or owners.

Table 1.8.5 Authorized institutions’ views on removal of the IRRs

24-hour deposits 65% 79% 59% 51% 75%

Savings accounts 71% 89% 63% 56% 84%

Current accounts 81% 96% 75% 67% 92%

Source : Regulatory survey

Interestingly, few institutions viewed deregulation as an opportunity and only 17%

considered that they would be able to attract new deposits in such an environment.

DTCs and banks were the most pessimistic, with only 6% and 11% respectively considering that they would be able to attract deposits.

Locally incorporated licensed banks and multi-branch foreign banks felt that this would increase the volatility of their deposit base and would not help them attract new deposits.

They also reported that the move would cause them to lose market share and substantially reduce their profitability. Around half (48%) of the local banks indicated that this move would destabilise the banking sector, although overall, only 25% of institutions agreed with this.

DTCs generally felt that removing the IRRs would be negative for them, with a higher percentage of them (compared to single-branch foreign banks and RLBs) stating that their deposit bases would become more volatile, their profitability would reduce, it would destabilise the sector and that they would lose market share.

Single-branch foreign banks and RLBs generally gave mixed views. They did not, however, anticipate any substantial drop in market share or profitability as a result of the move, presumably due to their limited deposit-taking activities.

There was general consensus among local and multi-branch foreign banks (57%) that removing the IRRs would result in greater responsiveness of borrowing and deposit rates to underlying market conditions.

The main conclusion drawn is that locally incorporated licensed banks and multi-branch foreign banks see themselves as the main losers, while DTCs also see themselves as losing competitiveness. RLBs and single-branch foreign banks are unsure as to the effect.

One important issue noted in the interview process was that, even if the IRRs were to be eliminated, the current market conditions would make releasing them inappropriate at this time. The major issue noted overall is that banks almost uniformly expect that the release of the IRRs would cause instability in the market, in respect to both volatility of interest rates and deposit bases.

From the banking survey and interviews, banks indicated that if the IRRs were removed they would take steps to protect their market share and profitability. Their response in this respect would be to reassess the cross-subsidies that currently exist and to eliminate them if they are not profitable. Other responses to deregulation might include:

Ø instituting transaction charges and minimum balance requirements;

Ø increasing their Best Lending Rates; and

Ø reassessing branch networks and cost structures.

1.8.8 Future considerations

The IRRs have provided a measure of underlying stability in the retail deposit and residential mortgage lending market. However, the IRRs limit competition for certain deposits and raise questions about efficient allocation of resources. In deciding whether the remaining IRRs should be deregulated, a number of issues need to be considered.

Principally, whether the long term impact of restricting competition is outweighed by the need for interest rate stability. For example, if the IRRs are to remain in place, the incentives for banks to develop alternative financial products to reduce cost and attract more deposits are reduced.

From the perspective of consumer choice and fair returns to depositors, the argument generally used by the banks is that consumers receive other services in lieu of higher interest payments. This, however, results in inefficiency in the pricing of products and provides a subsidy to banks in the form of cheaper funding that discourages the forces of consolidation. This subsidy is provided at the expense of savers which is neither efficient nor equitable. With the IRRs removed, interest costs are likely to rise and this may lead to a consolidation in the industry as has been experienced in other countries where interest rates have been deregulated. The fewer surviving institutions will be more efficient, providing more competitive interest rates to savers and using fewer resources to provide intermediation services.

Ultimately, the basis for supporting further deregulation would be the improved use of society’s resources in ways that are more productive relative to the case under a regulated environment. The weaker institutions will lose out whilst depositors will gain higher returns and society will eventually benefit through more efficient intermediation.

Competition in international financial markets encourages development of both new products (such as combined savings and current accounts or sweep accounts) and more efficient institutions, but this process may be stifled in Hong Kong if banks are not allowed to compete for their funds.

While continuing the status quo is a reasonable regulatory decision during the current financial crisis gripping Asia, it is difficult to defend as a long term stance, given the competitive reach of the global financial sector. Shielding Hong Kong banks from this process will handicap the strongest banks from effectively responding to these forces by reducing the incentive to do so in their home market. It is essential, however, that the

process of further deregulation is carefully managed to avoid potential instability in the banking sector.

Implications of change

Modelling change

Given the importance of the IRRs, two models have been developed to measure the potential impact of interest rate deregulation on banking sector interest expense. Both models used interest rate and deposit data available up to the end of 1997.

Firstly, an econometric model was developed to assess the potential impact of revoking the IRRs on savings accounts and time deposits⁴⁵. This model reviewed the impact of the 1994-95 deregulation of time deposit accounts on deposit movements through to the end of 1997 and drew several conclusions:

Ø The interest rates on newly deregulated time deposits rise (bringing the rates offered on newly deregulated deposits closer to those for unregulated deposits (i.e. over HK$500,000)), providing support for the assumption that the IRRs had been binding (i.e. constraining banks from what they would willingly pay in an unregulated market).

Ø The deregulation of time deposits led to an outflow of funds from savings accounts to benefit from higher rates paid on time deposits. The volume of deposits in those brackets that had been deregulated (e.g. 1-month or 3-month) increased both in absolute terms and as a proportion of total deposits⁴⁶.

Ø The yield curve of newly deregulated deposits shifted to more closely match that of unregulated deposits, eventually settling at an interest differential of approximately 0.50% to 1.00% (i.e. time deposits of HK$500,000 or over typically pay 0.50% to 1.00% more interest than those deposits less than HK$500,000 in the same maturity bracket).

Ø Focusing on savings accounts and 1-month time deposit accounts under HK$500,000, at an interest differential of about 1.40% between savings accounts and 1-month time deposits, the proportion of each in relation to total deposits would remain stable. For example, if the interest differential became higher than 1.40%, funds would flow to 1-month time deposits from savings accounts. Conversely, if the interest differential was less than 1.40%, funds would tend to remain in and flow

Ø Focusing on savings accounts and 1-month time deposit accounts under HK$500,000, at an interest differential of about 1.40% between savings accounts and 1-month time deposits, the proportion of each in relation to total deposits would remain stable. For example, if the interest differential became higher than 1.40%, funds would flow to 1-month time deposits from savings accounts. Conversely, if the interest differential was less than 1.40%, funds would tend to remain in and flow