Latest AFI Notes FINA0501

Overview of the Hong Kong Banking System, the HSBC
Group, the Bank of China Group
Authorized Institution (AI) Restriction by Type

Banks (LB133) Restricted LicensedDeposti-taking
Banks (RLB46) Company (DTC45)
1) Min. Deposit Amount No Restriction HKD $500,000 HKD $100,000
2) Min. Deposit Maturity No Restriction 24-hour call 3 months
3) Min. share of capital of HKD $300M HKD $100M HKD $25M
AIs incorporated in HK
4) Min. Deposit of AI N/A N/A N/A
5) Min. shares of AI (public deposit)
HKD $3B N/A N/A
6) Min. assets of AI HKD $4B N/A N/A
7) Basel Capital Adequacy Ratio12% 16% 16%
(CAR) > 4/1993 allow rise from 8%
8) Registration Fee 47,340 384,270 384,270
Abolishment of Interest Rate Restriction

Gradually weakened from 1994
Abolish in 2001
Deposit Insurance
Supplied to all banks, to insure depositors from any bank failure
Moral Hazard
Encourage riskier loan
No such phenomenon due to liquidity in the banking sector
giving sufficient deposit to even small banks
Licensed Banks
- 24 in Hong Kong
- 3 dominating: BOC (17%), HSBC, Heng Seng → 2/3 of assets
- HSBC holds 51% of HS → HSBC + HS = 50% of market shares
- BOC: 12 sisters merged in 2002
- BOC: 2 sisters remain independent: Chiyu Bank + Nanyang
- DBS: biggest bank in Singapore
- Bank of America (Asia) Ltd was acquired by China Construction Bank in 2006
no restriction on min denomination & term to maturity

commercial banks provide normal banking/business consultative service.
accept all types of deposit taking/deposits of any maturity/size, grant loans/advances, discount trade
bills/ bankers acceptance, deal in gold/foreign exchange & other services
4 Big Banks in China
Asian Financial Institutions - 1

1. Bank of China
2. China Construction Bank
3. Agricultural Bank of China
4. Industrial Commercial Bank of China
Central Bank of China: People’s Bank of China

- CITIC Ka Wah Bank: incorporated in HK 中信嘉華銀行
- China Merchants Banks: incorporated in China, listing in HK 招商銀行
Restricted Licensed Banks

- Take deposit ≧ HKD $0.5M (or equivalent foreign currency)
- Investment Banks (issue IPO, capital raising),
Deposit-taking Companies
- many are subsidiary of Licensed Banks
- Take loan so small than LBs are not interested
income: finance co./take deposit/grant loans to medium/small business
Local Representative Offices

Foreign banks who are not eligible for license
not AI/real bank
accept deposit for small borrowers
$ Lenders:
no deposit taking, only lend money, can’t take deposit
not authorize in HKMA
offer loans under Money Lender Ordinance.
Balance Sheet of AI
Assets Liabilities
(Use of funds) (Source of fund)
Loan to customer 32% Deposit from customer 56%
Interbank lending 40% Interbank borrowing 27%
* Much lending from large banks and almost all borrowing from small banks
Liabilities
- Interbank borrowing outside HK mainly to PRC + Macau
- 2002, Banks’ lending outside HK < borrowing outside HK
- 2003 onwards, Banks’ lending outside HK > borrowing outside HK

→ Demand of HKD↑
∵ Speculation of RMB → Speculation of HKD
When RMB↑ , HKD↑ → Demand of HKD↑
- HKMA does not allow loans to a particular sector > 40%
Real Estate sector increases to 51%
- HKMA aims at a diversified loan portfolio
HSBC
1864 – First British Bank having Head Office in HK – Allow instant decision
1949 – Start acquisition of banks all over the world
1981 – Announcement of HK’s return to China
As major shares were held by HK Government and residents, worried that
if after the takeover, China can control the bank
→ Started acquiring shares of Midland Bank (top 4 bank in UK)
→ Diluted the major shares
→ Established as an universal bank
Now, no major dominating shareholders
3 largest bank in the world 1st in 1865 (HK), 2nd in shanghai (lost in China civil war)  concentrate on HK
rd
Reason of success
- Does not compete in one level playing field
- Quasi-central bank – Special privileges of HSBC
1. Note-issuing bank
- Seigniorage (benefits)
When bank issue HKD, it has to deposit USD to the Exchange Fund.
today can issue any amount of HKD as long as it has enough US$ to back up the issue at the linked
rate of HK$7.8=US$1.
Gain income-earning power but lost interests earning power for USD deposit
- Non-pecuniary seigniorage
Free publicity, confidence
print money can lend to borrows (coins/$10 notes issue by gov)
printing costs are borne by the Exchange fund, not by the note-issuing banks  note-issuing banks experience no
gain or loss. Now, shared by BOC(1993) and Standard Chartered
2. Banker, agent and advisor of the Hong Kong Government

Before the establishment of HKMA in 1993, HSBC took this role.
Now, HSBC still partially retains this role
HKMA is now the agent and advisor
∵ Government’s chequing account and savings account still uses HSBC
(banker only)

3. Alternates as chairman of the HKAB (Hong Kong Association of Banks)
After 1993, BOC, Standard Chartered, HSBC → 3 takes shift
4. HSBC chairman was automatically a member of the Executive

Council of the Hong Kong Government
Now totally abolished
5. HSBC was the management bank of the clearing house of the HKAB
Before 1996, HSBC is the settlement institution
- can earn deposits without paying interest
- can further deposit to elsewhere to earn interest
Now totally abolished
12/96 – present
Exchange Fund 外匯基金
Hong Kong Interbank Clearing Limited
HSBC BOC SCB BEA Citibank

* All these banks have to maintain a clearing account with HKICL
HKICL 香港銀行同業結算有限公司 – 50% owned by HKMA and 50% owned by
HKAB
Money deposited at Clearing Accounts is interest-free
EF can use the $ for good purposes and benefits will be shared by the
general public.
EF can have confidential information as regards the clearing accounts
Before 96, HSBC could access to those confidential information.
Pre 96 – Net Settlement System

- Allow for credit balance during a banking day
- inter-institution transactions during the day are accumulated
- Must make positive balance at the end of banking day
- At closing, no deposit allowed
- HSBC could charge penalty interest against failing banks
Post 96 - Real Time Gross Settlement System (RTGS) 港元即時支付結算
系統
- no negative figures is allowed
- transfer systems where transfer of money or securities takes place
from one bank to another on a "real time" and on "gross" basis.
- If insufficient money in Clearing Account → cheque not cleared →

put back to the end of the queue, in the hope that some other
transactions would bring money to the clearing account (within
each bank)
In HK, there is NO Minimum Reserve Requirement (used to regulate liquidity of

a bank)
∵ HSBC dominates and opposes to it because HK has no central bank
If MRR is lowered, the bank will have access to more cash (Now, MRR = 0)
Clearing Agent
Before 7/1988
HSBC
HSBC BOC SCB BEA ….. [10 settlement banks]

- Each of these banks had to maintain a clearing account with HSBC, which
acted as the Management Bank of the Clearing House of the HKAB.
- Net Clearing Balance (NCB) could be controlled by HSBC, but not the
government
- 3 advantages of HSBC
1. HSBC can free-usage of the money on the Clearing Account, as the
money is interest-free (while expense of Clearing House shared by all banks)
2. HSBC can know about information about its competitors
3. HSBC can charge penalty interest on negative account balance
member banks are forbidden to organize/join other clearing arrangement
appoints itself permanently to run Clearing House
B: interest-free deposit
Government cannot change NCB but just can persuade HSBC to change
Between 7/88 – 12/96 (Net Clearing Balance = Sum of clearing accounts)
B was determined by EF.

EF
B did not pay interest.
B
HSBC
HSBC BOC SCB BEA ……

- HSBC could control NCB (generate income, want to increase)
- If B < NCB, then HSBC has to pay penalty interest
- If B > NCB, then (B-NCB) will be a zero-earning power asset
suboptimal level, rather raise to earn more income

* HSBC would want NCB to be as close to B as possible
HSBC no longer enjoyed free usage of money in clearing accounts
But HSBC still retain “penalty interest” advantage and still get information
about clearing positions of other banks
NCB ↑(↓) → HKD interest rate ↓(↑) → HKD/USD exchange rate ↓(↑)
NCB increase, more liquidity in banking system, $ less value, HKD i rate go down
make HKD less attractive (encourage others to borrow $)
 investors/saves will sell HKD and buy USD to earn higher interest  HKD
weaken against USD
EF change B so that the exchange rate is very close to Linked
Exchange Rate System
change NCB
i) borrow or lend money from other banks
ii) buy/sell USD versus HKD with another bank (HSBC buy HKD from BEA,
decrease NCB)
iii) buy/sell EF papers from other banks
EF borrowed from a bank, Aggregate Balance decrease
EF lended money to another bank, AB increase
EF bought EF papers from a bank, AB increase
EF sold EF papers to a bank, AB decrease
12/96 – present
Exchange Fund Settlement Institution
Clearing agent
Hong Kong Interbank Clearing Limited
HSBC BOC SCB BEA Citibank

RTGS applies
The new system increases the robustness of our banking system
HSBC lost “penalty interest” as no negative figure allowed
HSBC lost “information”
This system applies to HKD only
X NCB → AB (Aggregate Balance)
Aggregate balance
 The sum of balances in the clearing accounts and reserve accounts
maintained by commercial banks with the central bank.

2000, a system for USD was set up
(RMB) (HKD) (USD) (Euro)

CMU
DVP
BOC EF DVP DVP HSBC
CCASS
PVP PVP
HKICL HKICL Processor
HKICL
Not yet
implemented
2003, a system for Euro was set up,

HSBC = settlement institutions, HKICL = Clearing agent
- PvP (Payment vs. Payment) (Cash to Cash)

Both transfers will take place simultaneously, so that risk of counter
party defaulting does not arise.
Counterparty Risk: if one party defaults, the other party will be in great trouble.
- DvP (Delivery vs. Payment) (Security to Cash)

a. CMU (Central Moneymarkets Unit) 債務工具中央結算系統
A clearing system for debt securities
b. CCASS (Central Clearing and Settlement System) 中央結算系統
A clearing system for equities and debt securities listed on HKEX
Transfer of shares (transfer of title) and deposit will take place
simultaneously.
HSBC can enjoy free use of USD and can obtain information about clearing
position of USD of other banks
Settlement institutions simply take instructions from clearing houses.

Clearing agent do the clearing.
Can be HKD vs. USD, HKD vs. Euro, USD vs. Euro
If HKD vs. CAD, that would NOT be on a PvP basis.
no local interbank clearing system for CAD

Regulatory framework of the Hong Kong banking sector, the
Hong Kong Monetary Authority
Why need regulations?

1. When a bank fails, bank depositors would be hurt. It may cause a loss of confidence in Hong
Kong as a financial centre, since a failure of a bank may lead to failure of another.  affect whole
economy
2. Act as an agency, as most people do not have knowledge to assess the
safety of a bank, so deposit taking companies have to be regulated.
Liabilities of a bank: Deposits Rather short term

Inter-bank Loans
Assets of a bank: Loans given by banks} Long term
* Mismatch of maturity → Low liquidity → cannot bear a run
When people withdraw money, problem of liquidity arises.
liabilities are short term/assets are long term, long cover by short term can only survive if no bank runs
Usually, a central bank would lend money to a troubled bank so as to restore

public confidence, but Hong Kong has no central bank.
- Heng Seng Bank did not want to ask BOC of help, rather it asked HSBC. HSBC
agreed to help and HSB transferred 51% ownership
1948: Bank Ordinance (vague/ineffective): little regulation/easy to form bank
1961: Run on Liu Chong Hin Bank
1964: revised form commissioner of banking office, min capital/ratio requirement
1965: Collapse of Ming Tak Bank and Canton Trust and Commercial Bank.=>Panic big banks help gov (HSBC,
BOC), cultural revolution  HSBC dominate (acquired Hang Sheng Bank)
1965-78: stop issue new bank license (enough bank, need settle after crisis)
1967: Revision of the Banking Ordinance, Banking commissioner powers enhanced and min cap requirement
raised
1982-86: Hang Lung Bank, Overseas Trust Bank海外信託銀行, HK industrial and Commercial bank, Wing On
bank, Hong Nin bank, Union bank had financial problems
1986:Banking ordinance amended Banking Commissioner powers enhanced, min cap raised also
1989: licensed DTC  RLB, registered DTC  DTC
1993: establish HKMA

Regulations of banking system
HKMA
- Commissioner of Banking (a branch of HKMA) 銀行業監理處
a. Regulate banking sectors
b. Manage EF, sustaining the linked exchange rate system
c. Manage the clearing system of the banks
d. Promote the growth of the financial sector in HK
Four avenues through which regulatory regime regulates banking sector:
1. Entry Control
* Licensing requirement
Banking Ordinance
- Each LB, RLB and DTC has its own regulations
- All banks in HK are called Authorized Institutions
- Managers of banks have to be “fit and proper”, if one has broken
the law before, one would not be “fit and proper”
< 1978 restraint excess competition on bank licenses,
> 1978 “one building condition” 一間分行 (run business in 1 building, protect HK banks from
foreign banks)
> 1994 allow to have one regional & bank office
1999 3 offices in 3 separate bldgs
2001 all cancelled
2. Price Control
Eg. Interest rate restrictions
- Cannot give depositors a higher interest rate than that set out by HKAB.
- 2001, abolished, and no price control anymore
benefit large banks: offer convenience to customers with numerous branch,
interest rate restrictions (max deposit interest are) reduce excessive competition among
banks
small banks can’t allow i rate ceiling, high rate  high cost of fund  loans lend to customer
great risk
3. Product Line Control

Eg. DTC and RLB
- Minimum deposit and minimum maturity
Eg. Banks are not allowed to lend more than 70% on a mortgage loan
- Although people may get another 20% on other loans, banks would have
priority over those other loans and get repayment from the sale-price of the
house first

banks are forbidden to offer certain types of liability/purchase certain types of
assets, protect small depositors by preventing them from depositing in more risky
institution.
In US, Glass-Steagull Act (1933)

- requires separation of commercial banks from investment banks
- Commercial banks not allowed to engage in I-banks’ activities.
- Gradually weakened in 1990s and abolished
Some European countries have abolished such statues to make European I-
bank financially stronger than US I-bank.
before depression/collapse of stock market, commercial bank highly involved in stock
market, chain effect on economy.
It was a US law cancelled in the 90s HK never had such a law.
i) restrict commercial banks to be involved in securities-related businesses
ii) weaken the competitiveness of investment banks because they were not affiliated
to a large commercial bank
4. Ratio control
a. Liquidity ratio
Liquidity Liquefiable assets >

=
Ratio Qualifying Liabilities 25%
- Liquefiable assets: assets convertible into cash within 1 month

=
(cash/gold/loans)
- Qualifying liabilities: bank liabilities due within 1 month ( i rate
due/securities/)
Ensure that if there is a minimal bank run, the bank would have some
capital to meet the customers’ withdrawals.
ensure liquidity enough to meet liabilities
b. Capital adequacy ratio

Capital Capital
> 8% (Global-
Adequacy =Base
wise)
Ratio Risk Assets
In HK, For LB, 12%
For RLB DTC, 16% set by bank of Int’l Settlement
- Capital Base: sum of tier one capital (Core capital) and tier two
capital (Supplementary capital)
- Tier one capital ≧ 50% of capital base

- Tier one capital: Equities + perpetual non-cumulative
preference shares
Tier two capital: Inner reserves(earnings not disclosed)/general provision ($
set aside for loan defaults)/ subordinated debts (debts with no priority)
General provisions (not specific to a particular borrower)
Specific provisions (specific to a particular borrower)
- Risk Assets:
Risk assets weighting system (simplified version)
weight average of BV of asset items
Category Weight (%) Examples
I 0 Cash and gold
II 10 Short-term government securities
III 20 Long-term fixed-interest government securities
and claims on AIs
IV 50 Residential mortgage loans and MBS
(Mortgage backed securities)
V 100 Other loans, fixed assets and real estate
Risk Assets = sum of the risk assets after being weighted
Off-balance sheet items:

- items that do not show up on a balance sheet
- eg. Line of credits, written options, futures, forwards, warrants,
underwriting commitments, etc.
- have to be taken into account: each item would be given a
weight, and the figure is added to the sum
Ensure the banks have enough capital
5. Geographical control
Eg. In US, if you got a state license, you can only open branches in that
state.
Abolish in HK in 2001
< 2001: One building Restriction
- Early1960s, there was major banking crisis
- 1965-1978, Bank moratorium (No bank licenses issued)
- 1978, Bank moratorium removed.
- For foreign banks, if they wanted to have offices in HK, they could
only locate their branches/offices in one building
- If foreign banks were allowed to have offices in more than one
building
→ rental prices of property would go up

+ attracted too many customers which affected local big banks
(especially HSBC)
Counter-argument:
→ laissez-faire policy (free market with no gov interference)
- 1994, 1 building → 3 buildings
- 2001, completely abolished
- Singapore has similar restrictions to protect the banking sector.
Ensuring the ongoing healthy condition of banks
1. Offsite Inspection
Inspection of periodic financial statements / quarterly reports by HKMA
Sufficient measures against big banks
2. Onsite Inspection
Go to the banks and look at accounting records of banks
3. Triparty meeting
Between representatives of HKMA, the AI, and its external auditors
- CAMEL Rating system
Capital, Asset quality, Management, Earnings, Liquidity
1 (best) – 5 (worst)
Confidential to public
Any banks with rating 3-5 have to undertake further actions to satisfy
HKMA
4. Banking Ordinances restrictions

1. Advances against security of the AI’s own shares (capital
redemption in effect)
Owner cannot borrow money from a bank using that bank’s shares as
collateral
Example:
Original Owner puts $ Owner borrows $
into the bank from the bank
Assets Loans 100 100 105
Cash 0 5 0
Liabilities Equity 5 10 10
Deposits 95 95 95
Capital Adequacy 5/100=5% 10/100=10% 10/105=9.5%
Ratio undercapitalize
CAR will be useless without the restriction

2. Advances of more than 25% of capital base to a person or a group of
related companies
Aim: to avoid concentration. This concerns debt holding
3. Advances to directors and relevant persons of the AI
4. Advances to employees
Can borrow money from the bank, but there are caps on borrowings.
5. Holding of interest in land with value over 25% of capital base
Aim: to avoid concentration
6. Holding of shares in any company or companies with value over 25%

of capital base
Concern equity holding
5. Guidelines Codes
- Issued by regulators like HKMA
- If the bank violate the codes, HKMA can suspend or terminate the
license
Herstatt Risk
arises in foreign exchange transactions (or securities transactions) when one
counterparty delivers currency in one time zone and receives value in the other
currency in another zone.
Eg. When a bank advances money in one time zone to another bank in a different
zone, the first bank is facing Herstatt risk, since the second bank may not be able
to fulfill its payment rue to some sorts of reasons (hurricane, war started, etc.).
Example:
31/7/1991
HSBC had a transaction with its subsidiary in Kuwait. HSBC transferred money to
the Kuwait bank, but over the day, Iraqi army moved to Kuwait, so its subsidiary
could not make its payment. HSBC(HK) suffered a loss.
Way to avoid: have 24-hour banking all over the world

Money and capital markets in Hong Kong: the Interbank
Market, the Exchange Fund, the Linked Exchange Rate
System
Money market
Involve transactions of short-term money instruments, i.e. money transactions
with maturity of 1 year or less, examples:
 Treasury Bills (government loans of 1 year or less, none in HK, big in US)
 Commercial papers (CPs) (companies’ short-term borrowing,
excluding short-term borrowing of banks, debts for big name firms)
 Short-term negotiable Certificates of Deposits (ST NCDs) A
certificate of deposit with a minimum face value of $100,000. These are
guaranteed by the bank and can usually be sold in a highly liquid secondary
market, but they cannot be cashed-in before maturity.
 Trade Bills/Export Bills
 Bankers Acceptances (BAs) (short-term loan for manufacturers,
importer/exporters)
(eg. Toyota delivers cars to LA, LA would not pay until it receives the cars. In
the meantime, Toyota would need money for operations and shipment. LA
will get a LC. By supplying shipping document (to prove shopping of cars)
and the LC, Toyota would get BA)
non-existence in HK until 1990 coz no need to borrow $ to finance gov infrastructure.
Capital market
Long term market, involve transactions of money instruments with maturity of
over 1 year.
- Examples: US terminology
Note (>1 year – 10 year duration)
Bond (>10 years duration)
Stocks
Perpetual bonds
Situation in HK
- Hong Kong has no Treasury Bills
∵ Hong Kong seldom has budget deficit
- Exchange Fund Bill
Issued in 1990, maturity runs from 91 days to 1 year
- EF Note
Issued in 1993, maturity runs from 2 years to 10 years
Money market: EF Bills Useful tools for managing
Capital Market: EF Note interbanks liquidity
Hong Kong Money Market Instrument
1. Exchange Fund Bills

EF bills >3/1990 (91days/6months/1year), EF note >5/1993 (2-10 years)
gov in other country issue T-bills to raise money, HK exchange fund bill/note
i) instrument to manage interbank liquidity  impacts i rate ( then exchange rate  stability of link
exchange system)
ii) not money deficit
For management of interbank liquidity & LERS
2. Commercial Papers
CPs are issued by corporation (not common in HK dominance of
commercial banks)
Conventional Loan (Commercial bank)

Debt Financing
Debt Securities (Investment Bank)
Corporation
Fund Raising
IPO (Initial Public Offering)
Equity Financing
Private placement, venture
capital/direct investment, private equity
Companies prefer to choose debt securities

Borrowing money from investors
- interest is lower
- But higher on underwriting fees
Borrowing money from banks
- interest is higher
- Commercial banks acts as intermediaries
→ banks borrow from investors then lend those money
Primary market
- buying shares directly through IPO
Secondary market
- buying shares from existing shareholders
short term (< 1year) unsecured promissory note issue by large corporations (not banks,
semi-gov like MTR) to finance short-term working capital,
need underwriter/“underwriting syndicate” (underwriters share risk, denomination
>HK$500,000)

both public/bank can buy, sell to investors directly(own sale force)/indirectly(dealers)
3. Short-term Negotiable Certificate of Deposits (NCD)

Short-term paper issued by banks
Banks do not need this for short-term loans ∵can go to Interbank market
4. Inter-bank market
Smaller banks depend on inter-bank markets to borrow $ and to finance their
operation
(market of excess bank funds, HKD, among banks)
>1970, foreign banks set up DTC’s, but little very deposit (restrictions), want more $ to get in mortgage market
 borrow HKD from large banks (banks without extensive branch network esp. foreign banks, no license)
Source of financing Cost of funds Use of funds

Large Banks Customer Deposits Deposit rates Loans to customers,
inter-bank lending
(BLR+, HIBOR)
Small Banks Customer deposits Deposit rates Loans to customers
+ inter-bank market+ HIBOR (BLR+)
HIBOR: HK Interbank Offer Rate (rate that big banks charge small banks 
lend)
LIBOR: London Interbank Offer Rate, US$ LIBOR, €LIBOR, ₤LIBOR, CHF
LIBOR (used as reference for HIBOR)
TIBOR: Tokyo
SIBOR: Singapore
BIBOR: Bangkok (not important)
Federal Fund Rate: US
SHIBOR: Shanghai (Not very relevant yet)
rate big banks charge small banks to borrow $ from them (overnight/3D/1M/3M/6M/ 1Y)
No collateral is required
if HIBOR goes down, HKD will go down coz it loss attractive  HKD being attacked have to raise HIBOR
HIBID: Hong Kong Interbank Bid Rate 港元銀行借入利息

- less important
- borrowing rate set by big banks, because they are more dominant.
- HIBOR is always > HIBID
BLR: Best Lending Rate (Prime Rate) 最優惠利率

- Customer loans interest
rate banks charge to their best customers (few large banks dominant)
BLR
Usually > HIBOR > Deposit Rates
Always true
True;
Not always
- If HIBOR > BLR, then cost of funds > earning for small banks
no small banks are willing to borrow $ form big banks, as after small banks
also borrow $ to smaller firms/citizen, small banks still earn nothing, can’t
survive
- If HIBOR < Deposit Rates, banks would engage in Interbank borrowing,

instead of borrowing from customers
i) gain more interest in interbank borrowing, no customer can borrow $
ii) if customers can borrow $, prime rate (interest earn) is large then
borrowing cost, everybody borrows $ and earn difference, banks lose interest
HIBOR is set by the big banks. Small banks have no control.

* HIBOR is determined by supply and demand
If demand for Interbank borrowing ↓, HIBOR ↓
→ banks will lower the deposit rate or the big banks will ↓ supply
HIBOR can be > BLR

eg. 9/1997 Asian Financial Crisis
Overnight HIBOR 300%
1-month HIBOR 30%
→ small banks under threat, depends on HIBOR as major source of fund
Categories of banks
- Multiple branches
Locally incorporated
Foreign incorporated (License issued before 1965)
- Single branch
Foreign incorporated (gets funding from inter-bank market)

Hong Kong Financial System in Motion
1. Direct borrowing (from interbank)
2. Foreign Exchange Swap 換匯交易
counterparts undertake to reverse tran. at end of contract period at agreed rate
Parent-related Foreign incop.
bank outside Foreign currency Bank with single-
HK branch
Foreign
Exchange
Swap Borrowing
Ultimate
Foreign banks sell foreign
Interbank market borrower
currency for HKD
Swap
Local banks sell HKD for
foreign currency Placement
Non-bank Retail Bank

customers
Foreign Exchange Swap includes:

(Japan company come to HK, need HKD, use it’s yen to borrow HKD, return at
same rate afterwards)
- Spot transaction
(Today), eg. Foreign bank Sell USD to, get HKD from local bank
- Forward transaction
(3 months later) eg. Foreign bank Sell HKD to, get USD from local bank
- Diff between the forward/spot rate is the rate that the foreign bank
needs to pay
 Foreign exchange swap is less costly than direct borrowing
 Foreign banks with one branch do not receive much deposit and rely on
the interbank market heavily
 1-3 months are the most predominant maturity period
 From 2003, net lending by HSBC in Interbank market > net borrowing in
Interbank market, due to speculation of RMB

Mode Placement/ Borrowing Foreign Exchange Swap NCDs
Meaning interbank deposits buy/sell HKD against foreign extension of inter bank market
major supplier of HKD currency, require legal document,
Credit Unsecured borrowing Secured by foreign Depend on credit rating
currencies principal of the issue concerning
Cost HIBOR HIBOR (implied rate) HIBOR + liquidity premium
+ arrangement fees
Maturity Dominating in gradually more important, Exclusive in the 1yr or
Profile the 1m-3m towards 3m-1y above region
Management of Interbank liquidity

To protect robustness of linked exchange rate system
HKD Interbank liquidity↑→ Interest Rate↓
→ HKD/USD exchange rate↑(HKD depreciates)
→ affect linked exchange rate system
HKD Interbank Liquidity = Aggregate Balance
= Balance of Banking system
= Net Clearing Balance
88.96 96-present
EF EF
↑B ↑AB
HSBC HKICL
B and AB are the (interest-free) LIABILITIES of the Exchange Fund (EF).
Tools to liquidity management

Methods by which EF can affect AB, 88-96 (Past method):
7/88
1A. Borrowing from the Interbank Market
Balance Sheet of EF
Liabilities:
B/AB +/- 100
Interbank Borrowing -/+ 100
Not desirable
∵ pay HIBOR for interest, but EF is the safest, should pay lower interest rate
than banks but still have to pay HIBOR like other banks.
seems unfair for EF paying same borrowing rate (HIBOR) as other banks
Dis: i) entail credit risk,

ii) large-size borrowing/lending of long-term funds (>3m) may be difficult to arrange with interest in a
short period of time
1B. Lending to Interbank Market

Balance Sheet of EF
Asset Liabilities
Interbank lending +/- 100 AB +/- 100
Not desirable
∵ No collateral for lending → not secured lending
2. Buying/ selling of USD

Balance Sheet of EF
Asset Liabilities
USD +/- USD100AB +/- HKD 780
Affect exchange rate (direct impact)
Direct intervening of foreign exchange market which violates laissez-faire
policy (free market with no gov. interference)
3. Transfer of HKD Funds between Treasury and EF

Balance Sheet of EF
Liabilities
AB -/+ 100
General Revenue Account +/- 100 (EF reserve)
Only suitable for long term reserve
Not appropriate for short term reserve ∵ low liquidity
The treasury account is the account that contains the HK government's reserves. They can be deposited with a
commercial bank like HSBC, or they can be deposited with the EF, which is outside the HK banking system.
So if the government transferred its reserves (ie. the treasury account) from a bank to the EF, interbank liquidity
(AB) drops.
Transfer of Treasury Fund: Liquidity fund are used by gov, gov need to maintain a certain degree of liquidity ~
time deposit (long term) > not for sudden/short term borrowings. (invest in long term investment, long term
reserve, can’t use this treasury and EF route to earn money)
movement of funds between private & public sector does not affect level of interbank liquidity because the
funds stay within commercial banking system
3/90
4. Buying/ selling EF papers
Balance Sheet of EF
Liabilities

AB -/+ 100
EF Paper +/- 100
EF Paper
- Interest rate is lowest
- When buy back EF paper, would not expose other risks but just risk
of EF itself.
Problem: no secondary market for EF paper, is not very liquid, costly to use
this method
adv: i) to ↓ interb liquidity, issuance of EF bills & notes is less costly than direct borrowing,
ii) to↑ interb liquidity, unlike direct lending, buying back EF papers has no credit risk.
Carry Trade (息差借貸)

- Borrow a currency which is low interest and convert it to a currency of high
interest
- If HKD interest rate > USD interest rate, people tends to buy HKD and sell
USD
>3/90 Launching of EF Bills program:

sales, purchase and issue of EF bills and notes, interest of EF paper is lower than HIBOR
Adv: 1) can buy bring EF paper at any time 2) not intervene market 3) EF paper just pay risk-free rate not
HIBOR. Borrow $ at lower cost 4) buy back EF Paper involve no default risk.
Disadv: illiquid mkt > not feasible/high cost. fair (safest borrower)
Liquidity Adjustment Facility (LAF) 流動資金調節機制

Started from 6/92
HKMA management liquidity in market with LAF, HK version discount window
- allow the banks to deposit fund in the LAF
- Operates after working hour (4-5pm on weekdays, 1130am-12noon on Sat.)
allow banks with surplus/shortage to adjust balance
e.g. –ve balance, approach HKMA for liquidity assistance through LAF offer rate in
the form of Repurchase Agreements (Repo) involving eligible securities.
< Mar 94, only EF Bills and Notes were eligible.
LAF Offer Rate (borrow money)

V usually true
Overnight HIBOR (banks lending to banks is more risky)
V always true

LAF Bid Rate
(deposit surplus cash, banks lending to EF is always safe)
- Only available to banks which want to borrow money with security
When IPO, quick need of cash⇒liquidity squeeze⇒HIBOR>LAF offer rate (demand
increase, shift right, increase rate increase), HKMA inject liquidity to money market
(increase back supply)
Banks could borrow money from the EF via LAF and pay LAF Offer Rate, or deposit surplus funds in the EF via LAF and receive LAF
Bid Rate. Before the RTGS system was implemented, the LAF only operated after banking hours when the interbank market was closed,
so small banks that needed funding could not borrow from big banks and pay HIBOR (coz borrow from big banks need to be done during
daytime, so they have to borrow through LAF offer rate, which is higher than HIBOR); after 1996 when RTGS was implemented, LAF
operated during the day and would be useful when there was a huge rise in demand for HKD and O/N HIBOR rose above LAF offer rate.
12/96 implementation of RTGS:

liquidity adjustment window (LAW) operating during banking hours. (LAW offer rate = LAF offer rate)
Revised mode of operations (Mar 94)
Old: level of interbank liquidity as operational target changed infrequently,
fixed money supply⇒ shift in demand curve result in changes in o/n HIBOR.
New: o/n HIBOR as operational target, interbank liquidity adjusted frequently

in response to changes in demand to keep o/n HIBOR within the range of LAF bid & offer rates
⇒more stable ex rate.
Eligible Securities
- Category A: EF Papers
HKD debt securities
i. HKD statutory papers (Statutory body: MTR, HKMC, Airport Authority)
ii. HKD AAA rated paper (Rating agencies: Standard and Poors, Moody’s,
Fitch IBCA)
- Category B: HKD debt securities
i. Cleared through CMU (Central Money market Unit service operate by
HKMA)
ii. HKDA- (A3) rated paper issued by bank LAF offer
A - (A2) rated paper issued by non-bank + 1/4%
(Must be marketable, EF can take over the collateral before the bank
default)
Category B – USD/Euro denominated securities, subject to exchange rate risk
↑risk →↑lending rate imposed
Repurchase Agreement (repo)

Vehicle for EF to lend
- Banks sold securities to EF at a lower price and agreed to buy it back at a higher
price later
Difference = interest that banks pay to EF
Rationale:
- By the time, money is lent out. Title transferred to EF already
- No risk that EF is unable to claim security
* From bank, reverse = sold then buy
Repo done by CMU

Linked DVP
CMU HKICL
- Title changed by CMU (Central Monetary Unit)
- Fund increase by HKICL
CMU handles debt securities transfers. CCASS handles transfers of securities listed on the HK Exchange.
HKICL handles money transfers within the HK banking system
US
US HIBOR = Federal Funds Target Rate
LAF Offer Rate 1.5%> US Fed Fund Rate 1.5%> LAF Bid Rate
- Federal Open Market Committee (FOMC): US central bank committee

Meets 8 times a year, roughly once every 6 weeks on a Tuesday
Monetary Policy Options set in meeting:
1. Open Market operations (eg. Buy & sell treasury security)
2. Adjustment of interest rates
Federal Funds Target Rate
Discount Rate (similar to HK’s LAF offer rate)
3. Adjustment of statutory reserve requirement
* minimum reserve is not applied in HK
FOMC → Adjustment of rates → LAF Bid & Offer Rate

(+ Balance of banking system) → Overnight HIBOR → Other HIBORS
→ Deposit Rate + BLR → Other Loan Rate
after the Fed has set the Fed Funds Target Rate, HKMA set LAF Bid and Offer Rate (before 7 technical
measures) and sets discount window base rate now.
all other rates (HIBORs, deposit and prime rates) are determined by market forces
Discount Window Base Rate = 1.5% + Fed Fund Target Rate

→ ensure the rate in HK does not differ too much from that in US
∴ 2 not available in HK
HK perform 1 only to ensure HIBOR is close to the US rate
US HK
Discount Rate Central Bank to Commercial Bank LAF Offer Rate/ DWBR
Federal Funds Rate Commercial Bank to Commercial Bank Overnight HIBOR
Prime Rate Commercial Bank to Best customer BLR
Treasury Bills 3M – 1Y Exchange Fund Bills
Treasury Notes 2Y – 10Y EF Notes
Treasury Bonds 20Y-30Y /
People do not have confidence on HKD and the linked exchange rate
→ HK does not have long term debt paper
Now, strong China economy, strong RMB → Strong confidence on HKD
→ Proposal for LT debt paper
S2 S1 S3
D1 D3
D2
LAF Offer Rate
O/N
HIBOR
LAF Bid Rate

Balance of banking
system
- When people dump HKD to buy USD. D shifts to left, interest rate↓(D1D2)
- When there is an attack to HKD, EF could↓money supply to counter react
and ↑interest rate (↑HIBOR) (D1D3)
Liquidity Adjustment Window (LAW)

12/96
- Operate during banking hour
∵ Banks are not allowed to have a negative clearing balance
- In HK, only 3 large banks that usually have surplus funds
smaller banks may not be able to borrow $ from big banks even though the
HIBOR is lower - These banks have to resort to the LAF which has higher interest
rate

- LAF Bid no longer exists nowadays.
By 1998 all banks in HK should have enough experience with RTGS and should be able to manage their
clearing balances prudently, meaning they should not have too much surplus cash left in their clearing
balances at the end of the banking day, so the LAF deposit facility should no longer be needed.
Adjust B by adjusting fund

→ Fed Fund Target Rate is met
Fed Fund Target
Rate
B2 B1 B
LERS (Linked Exchange Rate System) (15 Oct 83)

variant of currency board; note-issuing banks must hold Certificate of Indebtedness (issued by EF), as cover
to issue HK$ notes; CI pay US$, EF promises to issue/redeem CI at fixed rate US$1= HK$7.8;
LERS was designed so that HKD is pegged to the USD at USD1 = HKD 7.8, or is
allowed to float within a narrow band around that rate.
Linking the LAF Offer Rate or the Discount Window Base Rate to Fed Funds Target Rate or the US Discount
Rate (in the past) were just measures to affect market demand and supply so that the market exchange rate of
the HKD would not deviate too far from the pegged rate.
9/98
- To hold Linked Exchange Rate System(LERS)
- To fight speculators 投機者;投機商人
Modification of Currency Board (HKD  USD, worry HKD too weak)
Reserve Management + Currency issuing body

Hard Asset Domestic currencies (fixed rate)
Banks
Market Rate
Public
- Not work in HK, HK has a more complex system
This system only worked in the past when coins and notes are the major parts of the
economy.
11/83 – 1/94
EF
CI to print USD10 (back up money in USD)
HKD78 notes

Note-issuing USD 10 Other Licensed
Bank HKD78 notes Banks
HKD/USD Market Rate
Public
* CI = Certificates of Indebtedness
- If HK$80 = US$10, banks will give HK$78 in return for US$, gained HK$2 (HKD
weak)
- If HK$76 = US$10, public will give US$10 to the banks and get back HK$78,
banks will then give US$10 in return for HK$78, gained HK$2 (HKD strong)
Balance of payment = Current Account + Capital Account + Financial Asset

Current Account
- Exporting > Importing → Current A/C positive
∵ Exporting earn USD and converted into HKD
- Importing > Exporting → Current A/C negative
∵ Convert HKD into USD
Capital Account
- If investing overseas > overseas investing in HK, more HKD have to
be converted into foreign currency → Capital account negative
LERS Mechanism
Positive Balance of Payment
Deflation Public sells USD
and buys HKD
LERS causes a
Decline in HKD supply HKD ex rate strengthen
HKD ex rate weaken LERS causes a rise

In HKD supply
Public buys USD
And sells HKD Inflation
Negative Balance of Payment
Later  agree to go minor change
8/2006
HK$ Notes + coins = HK$ 156 billion
M1 = Notes + coins + demand deposits = HK$ 357 billion

M2 = M1 + savings & time deposits in licensed banks = HK$ 2571 billion
M3 = M2 + savings & time deposits in RLB & DTC = HK$ 2589 billion
- Notes and coins constitute very small % of M3

- System above will collapse if want to change all M3 to USD
- EF Foreign assets = HK$ 1017 billion
Only cover M1. Not enough to cover M2/M3 into USD (for system backup
and buy back HKD to stabilize the exchange rate )
∴ system vulnerable
-
if investors sell a lot of HKD, EF only have M1 amount of $ to reserve (to buy back the HKD with the use in
USD, but the amount is only 5-6% of total M3)
Now EF will buy back CIs as well as the Aggreate Balance, the sum of the two is about twice the amount of
notes issued if all EF papers are converted into Clearing Balances. EF actually has more than enough USD
assets to do that
In 1998, a new accounting system is introduced

- Ignore capital account before
- Due to strong real estate market, positive current a/c
∴ HKD always on strong side (HK$7.6 v US$1)
Problem comes when public use HKD note to exchange USD
- Not profitable for banks
- All excess HKD notes would be converted to USD by banks, and
lend them out for interest (especially smaller bank)
- Recover loss → charge service fee for HKD→USD
→ create grumbling
HKD is linked to the USD, so when the USD weakens, HKD weakens along with it and that is an
important reason why we have inflation today
if HKD 4 = US 1, HKD stronger, can buy more USD stuff, more import, demand for USD increase,
demand of HKD decrease, interest rate decrease, deflation
1/94 – 9/98
Licensed bank waived service fee
Exchange money with note issuing bank at market rate instead of linked rate
EF
CI @

HK$78 US$10 link allows unlimited convertibility
In notes
3 Note-issuing Banks in foreign exchange market the exchange
Market Rate rate is allowed to float freely determine
Public + Other Licensed Banks by supply/demand, stability (market i
rate close to fix rate), endured by
arbitrage and competition mechanism
System even more vulnerable than previous one, susceptible to attack

- This system has the problem of only converting HKD notes, but not saving
accounts, etc. (Notes account for 6% of total funds in HK)
→ only 5-6% of M3, can attack it (people sell HKD, demand decrease, back up
not enough to cover, cut demand to increase price, increase interest rate)
- Only 3 note issuing banks are involved which have the incentive to exchange
at a better rate, so more susceptible to attack
- Other licensed banks no longer make any profits by exchanging money with
the public, no incentive to absorb HKD when public dumped
1997, speculators want to attack HKD, they will first have to borrow HKD from
banks and then sell HKD for USD
S1 S2
D1 D2
LAF Offer Rate
LAF Bid Rate
Government did not shift S ∵ do not want to weaken HKD

→ interest rate increases sharply → stock market decrease
→ speculators further short sell → earn a lot
If S is allowed to move to the right, then the speculators will be in hold of

hundreds of billions of HKD. The system would collapse. Government is
concerned about the verifications of both scenarios
Repeat Borrower Rule (after 97 measure)

Banks which borrowed from LAF on more than 4 consecutive days or more than
8 times in a 25-day period will be penalized.
→ S cannot move to right too much
→ Overnight HIBOR rises to 300% and 1M HIBOR rises to 30%
→ speculators short sell HIS when interest rate increases, stock market↓
Seven technical measures (9/98)

further strengthen the currency board arrangements and make them less susceptible to manipulation by speculators
to produce extreme conditions in the interbank market and interest rates. (2nd speculation after AFC in 1998)
1. Allow banks to exchange USD at HKD/USD = 7.8/1 (convertibility

undertaking)
Give incentives for the banks to buy HKD from the speculators when HKD is
weak
→ Demand for HKD balancing the supply of HKD
All the banks can use the clearing account
↑ the amount of banks / HKD involved in the arbitrage (let banks also earn
the short sell like speculators do)
↑ the exchange rate from 7.75 to 7.8 with continuity to prevent disturbance
(Beginning on 26/11/1998, the exchange rate will move from 7.75 to 7.8 by
HKD0.0001 per day, reaching 7.8 in 500 days) to make continuous or else
from 7.75 to 7.8 directly, market will have a huge shock
9/98 – 5/05
EF
CI@HKD78 in notes USD10 CB HKD78=USD10

3 note-issuing banks Other licensed Banks
Market rate
Public + Other Licensed banks
also single way (HKDUSD ,afraid HKD too weak)

As of 8/06
HK$ Notes + Coins HK$156 billion
EP Papers HK$130 billion
Aggregate Balance HK$1 billion
HK$287 billion
2. LAF Bid Rate is removed

1996, implementation of RTGS
Clearing account is always positive
To make sure all the cheque are cleared, banks will keep a lot of money in
the clearing account → surplus fund can earn an interest
2 years later (1998), banks know how much money to keep in the clearing
account → no longer need to keep a lot of money
Some banks do not lend money in the interbank market even though the
HIBOR rate is high. Instead, the banks earn LAF bid rate.
∴ EF remove the LAF bid rate
3. Discount Window Base Rate
Replaces LAF offer rate
determined time to time by the HKMA
1 O/N HIBORi + 1M HIBORi

= max US Fed Funds Target Rate + 1.5%, Z
2 5
* This is the rate for most of the time

* Simple average of the 5 day moving average of O/N and 1M HIBOR
4. Strapped the repeater borrower rule (remove the restriction of the

rule)
EF papers can be used as collateral in borrowing HKD
→ allow S to move to the right to a greater extent.
banks who over use LAF are penalized
for those who have EF papers as collateral, now can waive the rule
for those who don’t have EF papers as collateral, still have to obey repeat
borrow rule

5. Not to issue EF papers unless new funds flow into HK
EF papers under Measure 1 can be converted into US dollars
enabling that all new Exchange Fund paper will be fully baked by foreign currency reserves
6. If EP paper is used as collateral to borrow money from the discount

window
interest rate to borrow $, money borrowed from exchange fund, depends on
collateral used
introduce a schedule of discount rates applicable for different percentage thresholds of holdings of EF Paper by
LB’s for the purpose of accessing Discount Window, ensure that interest rate adjustment mechanism to be fully
kicked in when the HK$ is under significant pressure
Discount Rate = Base rate for first 50% of EF papers (held by LB’s)
Discount Rate = Base rate + 5% or O/N HIBOR, whichever is higher for next 50% of
EF Paper
7. Eligible papers can be used as collateral for borrowing money

Long term securities are accepted by EF as collateral in LAF (non EF paper to
borrow $)
HKMA has no control over the issue of HKMC, MTRC, etc. So EF do not want
these as collateral at the new discount window under (5).
However, there would be liquidity problem in the banks
So, still allow existing paper as collateral but with a higher discount rate
 Discount rate = Discount Rate in (6) + 0.25%
 All these long term securities are not accepted NOW
For existing HKMC/MTR and AA paper/triple A rate paper, discount rate on 6 will apply,
for others: discount rate = discount rate in 6 + 0.25%
no new issue of paper other than EFP will be eligible (abolished)
US$ flow to HK >(Measure 5)> EF Paper >(Measure 4)> Clearing Balance >(Measure
1)> US$ @ Linked Rate
New EF papers will only be issued when there is an inflow of USD to back up the new issue at the pegged
rate (Measure 5). The new EF papers can be converted to Clearing Balances (Measure 4). The Clearing
Balances can be converted to USD at pegged rate (Measure 1). Measure 5 ensures that Measure 1 can be
carried out.
Repeated borrowing rules still apply to non-EF paper

Borrowers using Discount Window on more than 4 consecutive days or more
than eight days over a 25-day period is liable for penalty.
prevent significant liquidity to be provided to licensed banks against paper not backed by Foreign Reserves
avoid borrowing much HKD then short sell and attack HSI; no control over non-EFP issuanc

98 system not well arranged to meet the measure
5/05 – present (both side this time, HKDUSD and USDHKD, now HKD too
strong )
EF
HKD78.5 USD10 HKD77.5 USD10
All Licensed Banks
Encourage banks to deposit HKD in the clearing balance
→↑supply of HKD to weaken the HKD
∵ concern about HKD being too strong
HKMA keeps HKD between 7.75 – 7.85 to 1 USD

- When there is a huge demand for HKD, it would allow licensed banks to
convert USD at 7.75 HKD. E.g. Market rate: HKD7.7:USD1. LB get USD1 from
public by paying 7.7 and exchange it with EF to get back 7.75 (earn 0.5 HKD for
banks)
US deposit and US deposits + (1)
Deposits + and US deposits - → Clearing Balance + (2)
- Note-issuing banks issue banknotes → CI + (3)
- When the banks issue banknotes → Liabilities on HKD banknotes + (3b)
- EF papers is the 3rd way that bank can make Clearing Balance + (4)
(* Clearing Balance, HK$ banknotes and EF papers are 3 money bases in HK)
- Clearing balance earns no interest → lend money out (5)
- Money borrowers buy things, resulting in another deposits (5b)
Balance Sheet of HK Banking System

Assets Liabilities
(2) + Clearing Balance (2) + HK$ Deposits
(3) + CI
(3) + HK$ banknotes (3b) + Liabilities on HK$ banknotes
(4) + Clearing Balance
(5) + Loans to customers (5b) + HK$ Deposits
(1) + US$ assets (1) + US$ deposits

(2) – US$ deposits

(4) – EF papers
(6) + Non EF non bank debt(6) + HK$ Deposits

Securities
(7) +AB (7) General Revenue Account (govt)
- As more US$ are converted to HK$, some banks may run out of HK$
- These banks sell US$1 to EF to get HK$7.8 while exchange US$1 for HK$7.5
for their depositors.
→↑Clearing Balance / Banknotes / Monetary Base
- Selling EF papers to EF →↑Clearing Balance
- Any transactions between banks would not affect the monetary base
Only when the EF get involved would affect the monetary base
EF, CI, clearing  money base, people can’t use it

currency, coins are money supply
money base generate money supply (back up USD, get CI, then money print is still not money
supply, have to withdraw money from the account  money supply under circulatation)
- When money leave HK, HK$ deposits does not decline until the loans to
customers mature. After the loans mature, banks do not want to lend out $
→↓HK$ Deposits →↓Monetary Base
- (5) Money Multiplier

M3 = total liabilities = 1/(1-x) x Principal
Mundell’s Holy Trinity

An economy cannot have (a) fixed exchange rate, (b) free movement of capital and
(c)
independent monetary policy at the same time.
Cannot have all three ticks
HK US
China
1. Free Capital Movement V V X
2. Fixed Exchange Rate V X V (can close)
3. Independent Monetary Policy X V V
- US does not link its currency to HKD. If HKD changes in exchange rate,

USD would not follow.
- China’s currency is secretly linked to a basket of currencies but not disclosed.
Only allow to vary in a very small range. Mainland aims at gradually free up the
exchange rate and the flow of capital.
In China, you must get permission before buying shares using RMB
- QDII (Qualified Domestic Institutional Investor)
- QFII (Qualified Foreign Institutional Investor)
Official Reserve
- Large reserve does not necessary a sign of strength
- Countries with trade deficit requires a larger reserve
Official Reserve Rank 2006
#1 China – First time in history
#3 Russia – increase in oil price pushup rapidly the rank
#7 Hong Kong – #1 per capita
- ∵HK has a small population
- → too much reserve, not good, not confident, show vulnerability
(sign of weakness)
- US has over 60 billion, but is the strongest economy, she does not need to
build reserve, ∵ people trust the US market
Exchange Fund
1. Backing Assets
- ~ 30% of EF
- Set aside to back up the monetary base (in case banks want to exchange
USD)
- Give people confidence on the linked exchange rate system
- HKMA wants a strong back up ∵backing asset > monetary base (usually
10% bigger)

- Backing ratio is 110.95%
2. Liquidity Portfolio
- To meet sudden need of huge liquidity
- HK$/US$ based
- US$ money market + fixed income investment with maturity within 1
year
- High credit quality (safe)
no ex rate risk, credit quality: important
Assets chosen for liquidity & ease can be sold to raise US$ cash when HKMA needs it
3. Hedging Portfolio
- HK$/US$ based
- To hedge for the cashing requirement of the EF
- To meet due liabilities by investment yields
- Investment in ST or MT items with interest payment
- Factors: Credit quality, maturity, HK$ & US$ money market, fixed
income security
4. Investment Portfolio
preserve value of the Fund for long term future benefit of HK people.
- US$/other currency based
- More concern on return; more diversification
- US$ money market and other currencies; credit quality; liquidity + return are all
considered
- Can have a longer term horizon for future
- Given to outside fund managers to operate
EF is managed partly in-house, partly by external fund managers (1/4)

external managers:
Managers are divided into pools, given identical inv benchmarks, guidelines & objectives.
Performance can be monitored against their index & each other. Reward gd managers with extra funds,
withdraw fund / terminate a portfolio for those underperform.
History of Exchange Fund

(1935-1972 linked to pound sterling; 72-74 US$; 74-83 flexible; 83 onwards LERS)
- EF was set up in 1935
- 1571 (Ming Dynasty): One-whip regulation (一條鞭法)

- all money are backed up by silver
- Japan followed
- Europe: Gold based currencies
- People used precious metals as money: gold/ silver/ copper
- Some less wealthy countries used courie shells
- HK: Silver standard, indirectly linked to Chinese Yuan
- any bank can issue paper currency, as long as silver backed
- 1920s, silver price↓, China currency↓, Export ↑

- 1929, Great Depression
- 1930s, world’s economy recession. Everything is collapsing in value except
GOLD
- 1930s, US silver mines suffer low price, US government buy at a price higher.
Chinese sell currency (Yuan to public) in exchange of silver at low price and sell
to US government. →↑supply of Chinese $ (Depreciation)
- Chinese government abolished the silver-linked currency system
- 1935, Currency Ordinance + Bank note Issue Ordinance

- Establishment of a Fund to buy out all silver coins and silver reserve in banks
- Banks sell silver to EF, in return for CI, indicating EF owe them certain
amount, then sold silver in London, converting into pound sterling, stored in
London
∴ ₤-backed 1₤=HK$16
- 3 note-issuing banks: HSBC, Chartered Bank of India, Australia and China
(today Standard Chartered), Merchantile Bank of India (taken over by HSBC)
- Lucky more: ∵ assets stored in London, Japan could not seize in WWII
- 1931-1945, second World War, No currency linked to precious metal

- 1941-1945, Japan occupied HK and issued duress notes that were not backed
up by anything. Japan issued a total of HK$119m where only HK$47m was
issued by HK banks to meet its obligation and HK$72m was issued by Japan’s
order
- After the war, HK banks immediately backed up the $47m with CI (pound
sterling). The $72m was not covered → huge liability
- Negative EF, which is first time in history
- Britain invest lots of money in, positive EF balance in 1950
- 1944, Bretton Woods System

- All Victoria countries gathered and came up a new currency system
dominating the world. Backed up currency by gold
- US$35 = one oz. of gold
- World Bank and International EF also followed
ensured the gold exchange system worked smoothly
helped poor countries
- Many countries linked their currencies to the US$ which in turn linked to gold
- “In gold we trust”
(ensure free trade, control int’l currency, pounds used to dominant, US replace
UK, USD replace pounds)
- 1964, Development Loan Fund (DLF)

- As EF did not need so much fund, money was transferred to DLF
- Transfer of HK$150M from EF to DLF
- After WWII, UK’s economy declined rapidly

- Pound sterling is linked to US$ at a very high rate
- Export < Import → pressure for depreciation of Pound Sterling
- Huge trade deficit in UK
- Britain was forced to devalue pound sterling against US$
- HK$ was linked to pound sterling, HK economy ↑rapidly
- 1967, 1 pound = HK$14.55 (originally HK$16)
- 1968, UK guaranteed to pay HK back at US$
Britain did not want to do this ∵ this will further drain gold to US
 Sterling Guarantee Agreement (HK-UK) UK gov and EF

UK Gov. B/S
Assets Liabilities
₤ US$
- Protect HK$ from further devaluation of₤(pay back loan in US dollars)
- No matter how ₤ changes/depreciates, UK will pay back HK at USD
based on the old exchange rate
- This would further press ₤ to devalue (UK can suffer a lot)
- US  UK depreciate
- US link to HKD, HKD suffer how much, UK pays back the lost,
- UK itself no profit, might even depreciate, but helps to protect HK
 Sterling Exchange Guarantee Scheme (EF-HK banks)

EF B/S
Assets Liabilities
₤ HK$
Help UK defense
- EF guaranteed the value of the pound sterling assets. If ₤ devalue
further, the banks will pay back based on the old exchange rate
- Inflation but gold was still linked to US$ at 1oz = US$ 35
- Gold became too cheap and people started to buy gold
- Price of silver is close to gold
- US reserves shrinked
- ∴1971, get out of gold standard
- Currencies that were linked to US$ became floated
- Bretten Woods System was officially abolished in 1973
- US was dominate in military terms, everybody trusted US$
- Currencies were not backed up by precious metals for the first time in history
* Nowadays, the world seems to have less confidence in US$, central banks
were switching to RMB, Euro or other currencies, or even to precious metals.
Speculators expected that gold and silver would prevail again.
But today, we are still using US standard Backing assets of EF
- 1972, Pound floated, US$1 = HK$ 5.65

- 1973, US$1 = HK$5.085
But there was still pressure on HK$ to strengthen
- Without gold standard, no need to keep the Sterling Guarantee Agreement

and Sterling Exchange Guarantee Scheme
- HK$ is strong → cannot decide the exchange rate
- 1974 – 1983, HK$ floated for a period of 10 years
- During this period, banks issuing banknotes simply deposited a certain HK$
amount before they could print banknotes. They would then get CI to print the
equivalent amount of HK$ deposited, less certain management fees. Thus
reserves were dominated in HK$
- 1976, General Revenue account transferred to “liabilities” section of EF
Balance Sheet → Negative balance sheet
- 2nd time that HK has a negative balance sheet (4 years)
- When HK$ is strengthened, the assets in ₤ dropped in value
- EF lost a lot of money (HK$ 700m)
- Before China’s announcement of takeover, HK$6.x = US$1

- After announcement, lowest rate = HK$9.6 = US$1
- China thought the range should be HK$7-8. HK$7.8 was picked because the
digit “8” is a good number according to Chinese tradition
- 1983, Linked Exchange Rate System, US$1 = HK$7.8
- 1988, New arrangement between HSBC and EF. HSBC had to deposit an
amount “B” with the EF

Money and Capital Market of Hong Kong: the bonds, debt,
forex and derivatives markets of Hong Kong
Capital Markets in HK
- Longer term market
- Note market (1-10 years)
- Bond market (over 10 years) in HK is NOT well-developed
- Bond market depends on investment bankers, who underwrites the bonds
and sell them.
- When big corp. need money, they would go to commercial banks for money.
- 2 routes to debt financing
Conventional loan – commercial banks
Debt financing (higher interest rate, lower fee)
Debt Securities (Bills, notes, bonds) – Investment
banks
(lower int. rate, higher fee)
Corporation
Listing on Stock Exchange
Equity financing
Private Placement (PE, UC)
- HK Stock Market Capitalization is high because Mainland corporations list in

HK (312.5% of GDP)
- Bond market is only 40% of GDP
Reasons for underdevelopment of Hong Kong bond market

1. Lack of a benchmark in the form of risk-free government securities
- NO LONGER RELEVANT
- If there is no benchmark, investors would tend to charge the companies
a higher interest since they are conservative. This is costly to companies.
- Government can always issue more currency to pay off the debts. So it
is assumed that government bills, bonds are risk free
→ safest kind of security → lowest interest
→HK Government has surplus, no need to issue bond
- 1990, we have debt papers – EF papers (longest 10 years)
EF paper was somewhat government-linked securities, this provides a
benchmark
- EF papers are, however of quite a short history
- * US government is the not same as HK’s. US securities may be an
imperfect substitute as a benchmark

2. Preference of retail investors for risk and rewards of equity markets
- Secondary market of bond is not active
- Common feature of Chinese-dominated market
- Chinese prefer stock market to bond market
- Bonds are now tied to stock prices or other commodity
3. Commercial bank dominance of financial sector relative to securities

firms
4. Absence of bond rating

- It would help if the bond is recognized and by an internationally
recognized bond raters.
- Hard for investors to estimate the risk involved in the bonds
- Investment Grade: BBB+ or above
- Investors cannot know how risky a company is if the company is the
graded by agencies
- Local firms are usually not rated
- Still an issue, RELEVANT, DIMINISHING EFFECT
5. Lack of a government mandated employee retirement or provident

fund
- NO LONGER RELEVANT
- Not until 2000, HK did not have a mandatory retirement fund (MPF)
- MPF usually invest in bonds
- Demand for bonds increases with MPF launched → growing demand
- 5% of salary is set aside for MPF
6. Unfavorable tax treatment for corporate bonds

- Unequal treatment between government bond and private bond
- EF paper, HK dollar paper issued by multilateral agencies: tax
exemption for trading profit and interest income
- 50% tax free if bond is longer than 3 years, bonds >7 years can get a
full tax exemption
- GETTING LESS RELEVANT
7. Non-EF papers no longer eligible for discounting at Discount
Window
- Newly RELEVANT
- Banks used to be leading investors on debt paper issued
- Tend to invest on good rating and safe bonds

- Banks concerned on liquidity. Before 98, debt papers can be used as
collaterals to borrow money from LAF
- After 98, only EF papers are eligible as collaterals
- Greatly amplified the liquidity problem, as debt papers cannot be
converted to cash
- Discouraged banks to invest bonds → ↓ demand
8. Low secondary market liquidity

- Retail investors are NOT interested in bonds. Little trading of EF paper on
market
- Bond holders might have to hold bonds until they mature or sell them at
discount
New “issues” of HKD debt instruments

- EF, statutory bodies, Government, Multinational developed bodies (MDBs),
non-MDBs overseas borrowers, AIs, Local Corporates
- EF is the dominant issuer (nearly half of the total issues)
- Government does not issue except in 2004
- AIs issues decline in current years
∵ banks are flooded with money, no need to borrow in debt market
- Except AIs, all other bodies show an increase issue of debt
∵ interest rate in HK$ is low
Outstanding HK$ debt instrument (accumulated amount)

- Non-MDB overseas borrowers are the dominant issuer
- Statutory bodies, Government, MDBs show decline in total borrowing
- EF shows an increase in the paper issued
∵ increase in US$ entering HK
(7 technical measures: no new paper is issued without increase in US$ entering
HK)
New fixed-rate and floating-rate debt issued in HK

- Majority of HK debt instruments are fixed rate
- Take advantage of the low rate
Average maturity of new fixed-rate debt excluding EF Bills and Notes
- Decline in the maturity
- The longer the maturity, the higher the interest rate
- Shorter maturity is more attractive
- Duration of debt instruments in HK is short
- In 2003-2005, the maturity of MDBs ‘ debt is relatively long

∵ Government required MDBs to issue bonds > 5 years
This requirement was abolished in 2006
Hong Kong Mortgage Corporation (HKMA)

- 1996, Statutory body set up
- 100% owned by HKMA
- Buy mortgages from banks
- HK has a lot of HKD, banks flooded with HKD, banks are looking for borrowers
(Borrowing rate BLR = 2~3% → indicator of large supply of HKD)
∴ bankers think HKMC is not necessary
Reasons for setup of HKMC

1. Meet increasing demand for mortgages
- Provide additional funding for mortgages
- NOT APPLICATION NOW
- Before handover, real estate market is very strong
→↑ Demand for mortgages
∴ forecasted a very high figure of mortgages needed, higher than the
banks can afford
→ give adequate funds for mortgages and help banks to maintain liquidity
- Not a good reason as real estate market soon collapse after 97
- Today: Mortgage Demand ↑ but HKD also flood into HK
∵ Demand for RMB ↑ (HKMC competing with banks for mortgages)
2. Promote banking stability
a. Reduction of over exposure of banking sector to property sector
- A 40% ceiling: i.e. 40% of loan portfolio of banks is linked to the property
sector (Maximum)
- If most bank loans are property-related, unhealthy when the property market
collapse
b. Reducing maturity rematch

- Property loans by banks → long term assets
Deposits by deposits → short term liability
if depositors withdraw → maturity mismatch problem
mortgages tie up a lot of assets of the banks which reduces liquidity
- HKMC can help by buying property loans/ long term assets from banks
and banks can replace them with shorter term assets
3. Provide fixed rate mortgages to homebuyers

- Banks prefer floating rate mortgages, able to adjust its expenditures

and earnings
- Homebuyers prefer fixed mortgages so that they can budget their
payments
∴ Mismatch between Demand of banks and home buyers
- HKMC issued fixed rate debt securities, money obtained from these
securities can be used to pay AI, thus, AI could issue fixed rate mortgages
- HKMC has to pay management fee to banks for securing the mortgages
(even if they are sold to HKMC).
∴ Mortgage market is normally higher than debt securities by 2%
- Banks becomes more willing to provide fixed rate mortgage
∵ can always sell to HKMC
4. Promote the development of bond market

- HKMC funding by issuing debt papers
- Help stimulate the debt market
Now: opinion that HKMC should close down

∵ compete with banks for mortgages
Conflicts between banks and HKMC
∵ HKMC wants best mortgage while banks want to sell the worst
Funding of HKMC
- 5% from HKMA capital
- Rest funded by borrowing
Mortgages *HKMC securities

Authorized HKMC Investors
Institution
$ > $
* Like other securities issued by statutory bodies
* Can be used as collaterals to borrow from LAF (before 7 technical measures)
* Pay interest rates very close to EF papers
∵ credits very close to HKMA, being a subsidiary of HKMA
- Income from mortgage payments used to finance HKMC securities
- Interests from mortgages should be > interests of HKMC securities
Maybe a 2% difference → Earnings > Costs (for financing HKMC)
- Interest to HKMC should be > Interest of EF
∵ administrated by banks and slightly riskier than EF paper

Preferred method: more sophisticated
Mortgages (guaranteed by HKMC)
AI MBS
Bauhinia MBS Ltd. Investors
HKMC $ (fixed rate MBS
buy fixed rate mortgages)
$ paid to AI & HKMC
- Bauhinia MBS Ltd.

 subsidiary of HKMC
 Package the mortgages: combine those with same maturities target, or
fixed rate/floating rate)
 Issue MBS
- Interest payments of MBS are legally backed by mortgages
i.e. Interest earnings from mortgages back the mortgages issued by Bauhinia to
investors
- CAR = Capital/Risky assets
If banks can remove risky assets, ↑ CAR
∴ banks are willing to sell mortgages to MBS
Whether banks are liable for default mortgages depend on contracts
- Some investment banks also issue MBS but the market is very small
Asset-back securities (ABS)

- debt papers or instruments whose interest payment are backed by income-
earning assets
 Mortgage-backed securities (MBC)
- Most common form
- MBS are guaranteed by HKMC
- In US, there are some backed by credit card (much higher interest)
 Collateralized Debt obligation (CDO)
- Debt security which can be backed by other bonds (income generating)
- CDO2: a CDO backed by another CDO
 Student loans
 Auto loans
 Tunnels + bridge tolls (Government issued securities)
 Rental properties

In US
Case #1
Structured Investment Vehicles (SIV) set up and owned by US banks
Mortgages MBCD
US banks SIV Investors
$ $
MBCD = Mortgage backed commercial papers (short-term instruments)

Mortgages = Long term liabilities
Long term liabilities financed by short term assets
→ Maturity Mismatch Problem
If investors refuses to buy MBCD

→ a lot of subprime mortgages
If there are default cases
→ people stop buying MBCD
→ SIV will have financial problems → heavily in debt
SIV is an off-balance sheet item of banks

If SIV has financial trouble (i.e. short of funds)
→ banks will give them loan * A PROBLEM
HK linked to US ∴ affects HK
Case #2
MBS
US Banks Hedge funds Investors
$ $
Loans (Hedge fund borrow $ from banks)

Banks heavily involved
Collateralized mortgage obligation (CMO)

- a special kind of CDO
- use mortgage as back up
- with different trenches according to risks
i.e. high risk → back up by high risk mortgage → pay higher interests
MBS/ABS Mortgages ABCD

US banks SIV Investors

$ $
ABCD = Asset Backed Commercial Papers
- Short-term liabilities
- Maturity date dues have to be issued again
- Long term assets mortgages/MBS/ABS (earn higher interest)
When SIV have liquidity problem

1. Sell mortgage/ABS/MBS at a discount
2. Borrow funds from banks to finance (short term)
∵ SIV sponsored by banks
Mortgages: subprime mortgages i.e. people with bad credit history

→ high risk
Second lien subprime mortgages
Foreign Exchange Market

2004, HK 7th among Foreign Exchange Market
- UK ranked 1 but not US
∵ many transactions are done in US$
- ∵ Euro is used, % change in UK is declining
- Hong Kong Foreign Exchange Market is larger than derivatives market (eg.
Forwards)
∵ HK bond market is small
- Derivatives market
- Interest rate will affect the profits/ downturn from bond market
1. Foreign exchange derivatives
2. Interest rate derivatives
- For hedging bond investments/exposure
- Very weak in Hong Kong
∵ bond market is very weak and the need for derivatives to hedge the
bond is low
Foreign Exchange Swap

- 2 banks enter into a transaction between 2 currencies today and agree to
reverse transaction at a future date at a rate which is agreed upon today
- Spot:
- A forward transaction
Reason for few cross currency transaction

- Big spread
i.e. buying and selling price will be very extreme
∴ advantageous
- Will use 2 step exchange
i.e. 1st exchange for USD, then USD to buy Euro/yen
∴ falls into category of USD exchange
Foreign Exchange Transactions include FE derivatives and FE swaps
Currency Swap
- involves the exchange of streams of fixed or floating interest payments in
different currencies for an agreed period of time and an exchange of the
principal amounts in different currencies at an agreed exchange rate at the end
of the period
- both parties end up with a lower interest
- e.g. Japan corporation wants to borrow US loan
US corporation wants to borrow Yen loan
Corporations have good connections with local banks and can borrow local
currency at a much better rate
∴ both borrow local loans and then swap
Japan Corporation will pay the USD interest rate
US Corporation will pay the Yen interest rate
both interest will be at a lower rate than if each corporation does not swap
2 corporations need to have an agreement on the exchange rate as exchange
rate fluctuates
(one borrow yen, one borrow euro, swap then have lower interest rate)
Interest rate Swap (Similar to currency swap)

- e.g. 2 corporations need loans
1 need floating rate loan and 1 need fixed rate loan
If rate is better, then the 2 corporations borrow loans for each other and then
swap with each other
- Loan amount must be similar and rates are good so that it is beneficial to
both parties (each get lower interest cost)
Convertible Bond
- Bond could be converted into stock
- Interests are generally lower (companies happy to issue  low cost)

**Convertible Bonds: tied to stock mkt  more attractive. Corporate bond with
warrant (with the right) to buy common stock of the issuer
It provides the upside potential of stocks (opportunity to participate in Co earnings)
with the downside
protection of bonds can be exchanged for a specified no. of shares of common stock
of the issuing company. Company stock rise, convertible bond price increase as
option to convert is more valuable.
♦ trade-off: convertible bonds generally convert to fewer shares of stock than you
could buy for cost of a bond.
Convertible bonds have the right to convert to common stock, it is also callable, the
company can force the bond holders to convert the bonds to common stock by calling
the bonds. Known as ‘Forced Conversion’.
When a bond is converted to common stock, the corp debt is reduced.

What was formerly debt was now been converted to equity.
Converting debt (bonds) into stock (equity) has the effect of diluting the equity.
If Co’s stock declines to a price which makes the convertible feature of the bond
worthless, as long as the company is solvent, the bond will trade based on its yield –
like any other bond.
There is a price level to which a bond will fall and drop no further as long as the
company can pay its interest and the principal upon maturity.
- CV Price: fixed price at which the bondholder can convert the CB into shares of
common stock
- CV ratio: no of shares which US$10,000 (HKD x 7.7235 pre-set exchange rate 
each bond has it’s own rate) worth of the bond can be converted into = (Denom*pre-
set ex rate)/CV Price (if conversion price = 2, 10000 x 7.7235 / 2  386.175)
- Parity: value of the shares that worth $100 of bonds can convert to in US$ in
today’s price = [(100*pre-set ex rate)(HKD/USD)/conversion price (conversion
ratio)]* (Current share price/current ex rate), usually the conversion price will higher
than share price share price = 1.37 (386.175 x 1.37 / 7.735 current exchange rate
in USD = 68.4)
- Premium: difference bet bond price and parity, time value of underlying warrant =
[(bond price/parity)-1]*100% = [(Bond Price/100)*(CV Price/Current Share
Price)*(Current/Pre-set ex rate)-1]*100%, usually bond price is > parity (price = 85,
premium 85/68.4 -1 = 24.3% difference called premium)

reason for recent increase in foreign exchange transaction in HK
1) depreciation of USD
2) increase in interest in investing in foreign currency + financial market to earn
high yields
3) increase liquidity in banking system + storage of the stock market
4) m China related activities
5) growth of wealth management business

Overview of China’s financial institutions
Mundell’s Holy Trinity in China

1. Independent monetary policy V (meet needs of economy, can boost/cool
as desire)
2. Fixed exchange rate V
3. Free movement of capital X (can exchange HKD for RMB up to 20,000)
- China is allowing the exchange rate to float gradually and freeing up the
capital flow
- 97, Asian Financial Crisis
Open exchange rate and movement of capital
→ overdone → Risk ↑
- China has strict control of capital account
Movement of Capital of China

- 2004 onwards, China started to allow entry of foreign capitals by QDII, QFII
 Qualified Domestic Institutional Investor (QDII)
- Allows domestic investors to invest overseas
 Qualified Foreign Institutional Investor (QFII)
- Allows foreign investors to invest in China
- Freeing up capital flow
- With some limit, RMB can be brought out of China
Exchange rate of China

- 1994, 8.7RMB = 1USD (combination of 2RMB rates, rate was too weak)
- Before 21/7/05, 8.28RMB = 1USD
- 21/7/05, allowed 2.1%↑ in RMB exchange rate, i.e. 8.11RMB = 1USD
- Allowed RMB to vary within a band
 RMB/USD is allowed to fluctuate slightly (+/- 0.3% / day)
 RMB/non USD is allowed to fluctuate more (+/- 1.5%/day)
- Not Feasible: 2 bands cannot hold simultaneously
∵ US and EURO exchange rate fluctuate too much within a day
RMB↑0.3% USD, EURO can↑1.8% maximum
If EURO/USD↑>1.8%, the band will not hold
- 23/9/05, RMB/non USD is allowed to fluctuate (+/- 3% / day)
RMB↑0.3% USD, EURO can↑3.3% maximum (before break upper ceiling)
if 2 bands hold together case:
if EURO↑3.5%, RMB still↑0.3% (↑difference with RMB >3% = 3.2% violate rule
2, if need this case to undergo, RMB need to↑0.5%, violates rule 1)

- RMB tied to a basket of currencies, USD is the major currency, not disclosed
by China
Peoples’ Bank of China Balance Sheet

Reserves of China
1.3 trillion USD – Largest reserve holding country in the world
Monetary Assets
- Foreign Assets
- Foreign Exchange, gold and other foreign assets
- Around 70% is USD
- Rumours that China changed the assets from USD to other currencies
∴↓ USD exchange rate
Liability
- Reserve money
- Money base
- Currency issue: 29 trillion RMB back up currencies issued
- Minimum reserve requirement: banks must keep 13% deposit on
reserve
- Bond issued
- Similar to EF Bills/ Notes
- Deposits of government
- Similar to treasury account
- Money that government deposit with Central Bank
Managing Interbank Liquidity by Central Bank

- Linked Exchange Rate System with US$
- Conducts monetary management to fight inflation and protect exchange rate
- China interbank market not well developed
Reason: SHIBOR (Shanghai Interbank Offering Rate) introduced in 1/07, which is
a new rate.
Open market operation to increase Interbank Liquidity is not effective in
controlling money supply/liquidity in China
∴ SHIBOR cannot affect interbank rate
Other methods to fight inflation by Central Bank

1. Adjust minimum/legal reserve requirement
- Central Bank is very powerful

- ↑ reserve requirement → banks cannot lend out more amount of money
→ increase interbank liquidity
2. Set deposit rates/loan rates of banks

- i.e. adjust maximum deposit rates, minimum loan rates
- China: the rates are highly regulated
- This control was abolished 5 years ago
- But Central bank still retains the right to control to fight inflation
- Recently, ↑ Maximum Deposit rates/Minimum loan rates
- This is unique to China
3. Sterilization
- Open market operation
- China with large trade surplus
→ Chinese exporters has lots of USD
→ having USD back to China convert to RMB
(since RMB strengthens and USD weakens now)
→ Banks have a lot of USD
→ Banks deposit in central bank
∴ PBOC has a lot of Foreign currencies
→ Banks need to issue more RMB or else RMB/USD exchange rate ↑
→ Inflation
- Solution:
PBOC issues Bonds, bonds absorb RMB back to neutralize the effect
- Problem:
USD assets earns USD interests
RMB bonds pays RMB interests
Now USD interests ↓
∴ RMB interests > USD interests
Cost > earnings, a very costly method
- Method still used, or else inflation
History of Central Bank

- 1949-1978, Mono banking system
All banks in China were subsidiaries of PBOC
- 1978-1985, Abolish the mono banking system
- 1986-1992, new banks established
Early securities market established
- 1993-1997, separate “Policy leading banks” and “Commercial banks”
- Shenzhen and Shanghai are the only 2 stock markets in China

Others made illegal
- 2002, Reform of capital and assets structure of commercial banks
- Aim: Clean up balance sheet so that a bank can be listed in stock
market structure instead of rural financial system
- 3 of Big 4 banks are listed
Structure of financial institutions in China

Government (State Council)
Central Bank PBOC State Administration of Foreign Exchange
- PBOC manage Foreign Exchange reserve (SAFE)
- PBOC set up investment company:
Central Huijin Investment Company
- With capital 200 billion
- Based on the investment of the foreign exchange reserves by SAFE
- CHIC invests in a way like Temasek (Investment company set up by
Singapore government to invest Singapore government reserve)
- CHIC invests China reserve in areas that are not liquid but have good
steady growth rate
- CHIC is set up for the purpose of capital appreciation in future
Regulations
- Past: regulate stock exchange and banks in China
- Now: primarily in-charge of conducting monetary management
- 2003, regulatory power of PBOC was removed
Government (State Council)

Central Bank PBOC State Administration of Foreign Exchange
Regulatory Organization CBRC, CSRC, CIRC
1. China Banking Regulatory Commission (CBRC)

- Regulates the banks
- Drafting of laws and regulations governing the back sector, licensing,
supervisions of banks
2. China Securities Regulatory Commission (CSRC)
- set up in 1994
- CSRC, PBOC and government wanted to regulate the stock exchange
market
- 1998, CSRC given full power to regulate issuance and trading of shares
- Licensing of dealors
3. China Insurance Regulatory Commission (CIRC)

Regulate Insurance sector by formulating policies an enforcing laws
HK
- HKMA regulates both banks and EF
- Securities and Futures Commission regulates insurance
Deposit Money Banks (following not that clear cut, but just in general)
5 State owned Commercial Bank
- Have branches all over the world
Listed:
- Industrial & Commercial Bank of China (ICBC)
- Bank of China (BOC)
- China Construction Bank (CCB)
- Bank of Communication
- Similar to big 4 banks
- Status increased to state-owned commercial banks
- Found to finance the railroad projects
- 1978, became independent
Not-listed:
- Agricultural Bank of China (ABC)
With a lot of bad loans, cannot clean balance sheet
12 Joint Stock Commercial Banks

- 7 listed and 5 not listed
- Government and non-government entities owned
- Branches limited to geographic scope
City Commercial Banks

- unclear distinction with Joint Stock Commercial Banks
- maybe have a even smaller geographic scope, confined to cities
Foreign Banks
- allowed to operate in China few years ago
- before, not allowed to handle RMB business
- if want to handle, need to have joined investments or loan with local banks
- 2002, China joined WTO, remove restrictions on foreign banks on RMB
business in 5 years
- Rules: Foreign banks need to set up a local bank in order to get involved in
RMB business (incorporated in China), need to maintain the CAR of China
incorporated foreign banks > 8%

∴ requires large amount of investment, very difficult for these banks to
establishes in China and do business
Cooperatives
- financial institution established to finance needs of its members
- takes deposits, make loans to members only
- become cooperative banks when big
- Cooperative banks become commercial banks when very big
- E.g. Rural Cooperative Banks converted to Rural commercial Banks
- Similar to Hong Kong Finance Companies and DTCs
Specific Depository Institutions

Policy Banks
- May make loans to sectors to support government policies
- 3 new banks set up:
- China Development Bank
Finance infrastructure projects
- China Export & Import Bank
Finance export and import business promoted
- Agricultural Development Bank of China
replaces ABC, finance agricultural policies
- Source of funding
make long term loans
difficult to raise capital by accepting deposits
raise funds by issuing bonds (purchased by Big 4 banks)
∵ Big 4 banks are indirectly policy driven
 E.g. CITIC (China International Trust and Investment Company)
set up in 80s before stock market developed in China to raise funds for
investment, borrow money from overseas and issue bonds
- Today stock market matures
∴ Trust and investment are less important now
can raise funds via stock market
China Postal Savings Bank

- originated form US
- set up because people before did not trust banks and put money under beds
- pay very low interests
- money raised was used to finance infrastructure projects
- US abolished in 1960s
- Japan wanted to convert them to commercial banks

- Important in rural areas of China to finance rural projects
Structure of non financing sectors’ liabilities

China: 69% of financing from bank loans
US: 16% from bank loans only, mainly from stock market
Implementation:
Stock market in China has a large growth potential
Asset Distribution of Deposit-taking institutions

Big 5 banks 55% of assets of all deposit-taking institutions
Shows dominance of big 5 banks
2002 Reform of capital and assets structure

* SOE – State owned enterprises
* SOCB – State owned commercial banks
Ministry of Finance (MoF) as major shareholder
Loan portfolio heavily accounted for non-performing loans (NPL)
Capital injection by the Government

Increase capital and reduce NPLs of SOCB
1998 Procedures:
1. PBC lowered legal reserve requirement from 13% - 8%
Free up RMB 270B of bank liquidity of SOCB
2. SOCB purchased bonds issued by MOF in 8/1998
3. MOF mobilized proceeds of bond issuance to inject capital in SOCB
4. PBC recalled part of its loan from the SOCBs to offset the inflationary impact
of the reduction of reserve requirement ratio
Balance Sheet of SOCB
A L
(1) – Reserve 270b
(2) + MOF bonds 270b
(3) + MOF capital 270b
(4) + Cash 270 b
Establishment of AMCs and the disposal of NPLs

* AMC – Asset management companies
AMC were independent and MOF was the only shareholder

4 AMC for 4 SOCB (1 for each)
- Huaray

- Great Wall
- Orient
- Cinda
AMC borrow money from POBC and buy NPL from SOCB
Transfer of NPL to AMC
Balance sheets
AMCs POBC SOCB
A NPL + 1384 Loans to SOCB -548 NPL -1384
Loans to AMC +548 AMC Bond +846
L PBC loans +548 / PBC loans -548

Bond Issuance +846
- Bad loans mostly made to State Owned Enterprise (SOE)

(Edge of bankruptcy ∴ cannot reply loan)
- Some loans → equity of SOE
- ICBC 25% loans → equity
- CCB, CDB 50% loans → equity
- Different country has different definition of NPL
- 97, old definition, 25% of loans of 4 banks are NPL
- With new definition, ratio of NPL increased
- 2002, transfer of batch of NPL to AMC
- Banks still had a lot of NPL
Second capital injection by the Government
Reason for the action:
- 2002, China joined WTO, required to open banking sector
- 2007, 12 foreign banks have established a locally incorporated branch in
China and with CAR of 8%
- If foreign banks can set up business in China easily, they can easily take over
the position of big 4 banks
∴ Big 4 banks need to clean the bad loans
- 1. Go public
- 2. Allow them to compete with foreign banks
- ∴ Led to second stage of cleaning of the big 4 banks
Measure:
1. Further capital injection (114 billion) in 2003
- 12/03, Central Huijin Investment Company was established
subsidiary company of SAFE
controlled by PBOC

∴ PBOC became a big creditor

Balance Sheet
SAFE Huijin
A L A L
Fixed assets -373 Fixed assets+373 Capital +373
Investment to HJ +373
- MOF still wants to retain its position as major shareholders of Big 4 Banks
- ∴ Refuses to write off all the big 4 banks NPL
2. Disposal of NPLs using market mechanisms

- Divide loans into 5 categories
 Performing loans (pays interest, no sign of default)
 Special mention (borrower appears to have some difficulties in finance)
 Substandard loans
 Doubtful loans (with some salvage value, certain that some will not be
collected) (NPL)
 Loss loans (certain that you cannot collect anything) (NPL)
- NPL need to be removed before Initial Public Offering (IPO)
- Big 4 banks allowed to transfer their NPL to AMC
1. MOF released its original paid-in capital to form receivable

2. PBC provided AMC with loans to purchase NPL
3. PBC required big 4 banks to purchase nearly equivalent amount of PBC
special bills
AMC Balance Sheet

A L
NPL +1240b PBC loan +619b
[ 1/2 doubtful loans (no cost)]
[ 1/2 doubtful loans (at book value)]
[Loss loans (no cost)]
SOCB Balance Sheet

A L
NPL -1251.9b paid-in capital of MOF -198b
MOF receivables + 311.5b PBC loan -28.4
PBC bills +588 b Reserves -107.8b
PBC speed bills +18.1b

3. IPOs
BOC in HK transferred all bad loans to Beijing (parent) in 2003
Went public in 2003
∴ ↑ bad loans of parent company
BOC in China went public in 2006
Reasons why banks can clear the mess in loans in China

- China has low fiscal deficit: 2% of GDP
- Government debt 25% or less of GDP (very low, danger level: 60%)
Reasons why companies in China not listed in New York

- Sabannes Oxley Act enacted
- Stringent requirement on banks and companies
- More difficult to abide with the act and cannot go public in New York
* State remains the major shareholder of the big 4 banks

* ICBC: biggest among the big 4 banks

Overview of Japanese financial Institutions
History
- Bretten Woods System
US help Japan with export and boost its economy by keeping its exchange rate
low
- US allowed Japan and German to peg exchange rate with USD
→ exports will be very cheap
∴ boosted exports → no desire for socialist/communist system
- System worked well from 1950s to 70s
- Problem:
US could not continuously buy exports from Japan and Germany
after 1971, free flow of currency
Japan and Germany did not allow the currency to escalate
even though there was a trade surplus
∴ drainage of USD away
- 1980s, US could not live with huge trade deficit

- ∴ Press Japan and Germany to raise its currency value
- 1985, US pressured Japan and Germany to agree with Plaza Accord
- Plaza Accord agreed among US to buy Japan/Germany currencies and sell
USD
- To push up the exchange rate between Japan/German$ and USD
- ∴ Yen appreciated by 30% in 1 year
- Plaza Accord reduces trade deficit against Germany, but did not reduce trade
deficit against Japan
- Japan used to have a lot of trade surplus against US
- So Yen should strengthen but it did not
- Reason: Carry Trade
Interest rate for Yen is very low, so borrow Yen at low cost
Investors borrow Yen and convert to other high-interest currencies to earn
interest
∴ Yen weakens
- 1987, Louve Accord

- To slow down appreciation of yen
- Raising Yen → Export cost ↑→ Profit Margin↓
- ∴ companies need to increase profit margin by boosting domestic market
- Japan increase engagement in monetary supply, print a lot of yen

→ asset inflation
- ∴ very expensive real estate and stock price
- 1993, Real estate and stock market collapsed

- ∴ a lot of bad debts were incurred in Japanese banks
- 12 city banks needed large-scale restructuring
- 2003, after restructuring, bankruptcy and merging → 3 main city banks

Banking system of Japan
Central Bank
Bank of Japan (BOJ)
- After restructure, not the regulator of banking sector
Regulator
Financial supervisory agency
Categories of banks in Japan

Cooperative type institutions (Kinkos)
- members from a cooperative and deposit in institutions
- have loans to members only
- expansion taking deposits and make loans to non-members and government
agency → develop into a small bank
Banks (Ginko)
Japanese City Banks
- Have branches all over Japan
- Take deposits from everybody, make loans to large corporations
3 new groups of financial institutions in Japan after restructuring
(3 main banking groups)

Old City Banks New City Banks Bank Holding Group
Bank of Tokyo
Mitsubishi Bank
Mitsubishi Trust Bank of Tokyo Mitsubishi
Nippon Trust 2005 Mitsubishi UFJ
Tokyo Trust Bank of Mitsubishi UFJ Financial Group
2001
Sanwa Bank (UFJ Bank)
Tokai Bank United Financials of Japan
Tokyo Bank
Mitsui Bank 2002 Sumitomo Mitsu

Taiyo Kobe Bank Sumitomo Mitsu Bank Financial Group
Sumitomo Mitsu Bank
Daiichi Kanggo Bank

Fuji Bank Mizuho Bank Mizuho
Industrial Bank of JapanMizuho Corporate Bank Financial Group
Nikon Kaggo Bank
Asahi Bank Resona Bank Resoma Holdings

Daiwa Bank Resona Saitama Bank
Mitsubishi UBJ Tier I Capital World Rank 6 (merged from 2 banks)

- 34.2% on loans and discounts
Regional Banks
- take deposits mainly from medium corporation and individuals
- loan to medium corporation and individuals
- loan to local government when they issue government bonds
- serve regions
- 23% of deposits and 25.6% of loans
Sogo Banks
- Second Association/ Tier II Regional Banks
- Set by Sogo bank Law, 1951
- Serve individuals and small enterprises
- 6.9% of deposits and 7.5% of loans
Foreign Banks
- minimal effect

- Japanese banks have strong bond with local corporations unless want to
expand outside Japan
Long-term Credit Banks

- finance long-term industrial projects and infrastructure projects
- cannot reply on short-term financing
- ∴ cannot liquidate assets if number of deposits falls
- Funding comes from debentures, long-term bonds
Old LTCB New LTCB
Nippo Credit Bank ------ Anzora Bank
Long-term Credit Bank of Japan ------ Shinsai Bank
Industrial Bank of Japan ------ Mizuho Group
Trust Banks
- focus on trust business
- wealthy business / people put money in trust
 Mitsui Trust, Sumitomo Trust, Mitsubishi Trust, Mizuho Trust, Sumitomo Trust,
Resone Trust
1. Money Trust
Customers entrust banks with their money for investment purposes
2. Pension Trust
Manage corporate pension trust
3. Loan Trust
Money trust that invest in loans and securities, more conservative
4. Investment Trust
Administer investment funds’ assets
Make sure that the fund managers follow the guideline of the trust funds
Do not make decisions itself
5. Securities and money claim trust
6. Testamentary Trust
Manage and administers the estate of customers
7. Charitable Trust
Manage assets of customers set aside for charities
8. Special purpose Trust
New type banks: Banks associated with a retail company or internet bank
1. IY bank
Ito Yokado supermarket chain associated

ATM machines located in the stores
Serve customers of the supermarket chain
2. Sony Bank
Set up by Sony, SMBC and JP Morgan
Provide services via internet to customers
3. E-Bank
Specializes in small payment using internet or portable phones
4. Japan Net Bank
Internet bank
Set up by SMBC, Fujitsu, Nippon Life
5. Japan Successor Bank
6. Postal Savings (Yocho)郵貯
Trust Fund Bureau – MOF (2001 X)
Postal Service Agency – Ministry of Public Management Home Affairs Post +
Telecom
accounts for 20% total savings of the banking sector.
Cooperative-type Financial Institutions (Kinkos)

Credit Cooperative (Shinyo Kumiai)
- serve SME/individuals in the regions
- take deposits from member (SME employees and family members)
- supervised by local government
Credit associative (Shinyo Kinko/Shinkin Banks)

- more like a bank which take deposits also from non-members
- supervised by Financial Supervisory Agency
- make loans still primarily to members
- make loans to non-members subject to approval
- source of funds:
member deposits, non-member deposits, loans from Shinkin Central Bank
- use of funds:
loans to member, deposits in Shinkin Central Bank
1. Shinkin Central Bank

- Central bank of all the shinkin banks
- Accept deposits from shinkin banks
- Redistribute surplus funds
- Not a regulatory body
- Source of funds:
deposits of Shinkin Banks, debentures, deposits from government bodies

- Use of funds:
Loans to shinkin banks, government securities
2. Shinkumi Federation
- National Federation of Credit Cooperatives
- Central bank of credit cooperatives
- Redistribute surplus funds from a well off credit cooperative to not so good
ones
- Not a regulatory body
- Invest in government securities
3. Shoko Chukin Bank

- Central bank for commercial and industrial banks
- Owner: Government + SME cooperatives
- No financial institutions under it
- Functions:
Sales and dealings of government bonds
brokers of government bond futures and options
trustee for private bond issues
Provide management consultancy advices to SMEs:
Long term planning, IPOs, private placement, provide information on overseas
market
- Office in London, New York, Hong Kong and Shanghai
- Source of funds:
Deposit from SME cooperatives, government bodies, non-profit organization,
other financial institutions; Debentures
- Use of funds:
Loans to member (SME cooperatives) and member companies
Labor Banks (Rodo Kinko)

- banks for labor unions and consumer credit association
- invest in local government bonds and invest surplus funds in Central bank
(Rokinren Bank)

Rokinren Bank
- Central bank of labor banks
- National Federations of Labor Credit Association
Norinchukin Bank
Credit Federation of Credit Federation of Credit Federation of

Fishery Cooperatives Forestry Cooperatives Agricultural Cooperatives
Fishery Cooperatives Forestry Cooperatives Agricultural Cooperatives
Norinchukin Bank
- owned by cooperatives
- provide remittance services + foreign exchange services
- Other functions:
provide on-line communication network nationwide for members
collection services domestically
provide payments for government purchase of commodities
act as agent in lending funds of the Agricultural, Forestry and Fishery
Finance Corporations
deals in government bonds and other securities
- Source of funds:
deposits from cooperatives, non-member borrowers, subscribers of Norinchukin
bond, government bodies, non-profit organization, financial institutions
- Use of funds:
loans to members and some non-members, government bonds and other
securities
Credit Federations
- do not engage in any non-finance services
- surplus fund invest in Norinchukin Bank
Cooperatives
- bring the members together and solve problems
- encourage social utility
- purchase and sales services
- surplus fund invest in Credit Federations

Government Financial institutions
Development Bank of Japan
- policy bank
- make loans to projects for development of infrastructure
- loans that commercial banks reluctant to make
- co-invest with commercial banks
- get funds by issuing bonds
Japan Bank for International Cooperation

- policy bank
- help financial project overseas especially third countries
- help Japanese banks to go overseas and improve relationship of Japan
government and overseas
Agricultural, Forestry and Fisheries Finance Corporation

National Life Finance Corporation
Japan Finance Corporation for small business
Japan Finance Corporation for Municipal Enterprises
Japan Small and Medium Enterprise Corporation
Okinarsa Development Finance Corporation
Credit Guarantee Association
Housing Loan Corporation
- help buyers not qualified for loans in commercial banks
Postal Saving (Yucho)

- tap the savings of small individuals
- branches at post office
advantage: no need to set up office which can save rent and convenient
- pay lower interest but usually tax free
- investing government bonds or securities
- used to help government financing
- Actually no need for postal savings in Japan as no need for extra fund, but
momentum issues (bureaucratic)
- 2001, Trust Fund Bureau lost control of Postal Saving
Postal Service Agency of the Ministry of Public Management, Home Affairs, Post
and Telecommunication takes control
- ∵ low interest yield → people want to invest elsewhere

Singapore’s financial institutions, money market, forex
market and Asian dollar market
History
- similar to Hong Kong
- former British colony
- simple structure
- affect by political factors
1965, Singapore independent

1968
- Many multinationals accumulates US$
- Asian companies also make money in US$
- Singapore wanted to become a regional offshore banking centre
- Source and use fund in overseas
- Attract funds and place funds all over the world
- * New York and London are 2 huge offshore banking centres
- Tap funds from small regions nearby
- Make loans to borrowers nearby
- Tap the funds in Asian dollar market
- In order to attract foreign depositors, banks are allowed to set up Asian
Currency Unit (ACU)
- Low tax rate is needed
- Tap the Asian money market and USD floating in Asia
- Problem:
still a developing country and need strong military
→ need high tax rate → drive away lots of investors
- Solution:
Transaction done in ACU enjoyed a tax relief
Banks can still do their normal business in foreign currencies but at a high
tax rate
Only non-Singapore currency business can use ACU
→ attractive to foreign companies with US$
- * HK: no need ACU because of low tax rate
- Domestic Banking Unites (DBUs)
- For Singapore$ transactions
- Liberal policies to attract foreign banks

- Do not want the foreign banks to overwhelm the local banks

- ∴ Foreign banks are set up with different license
- Restricted to business in Singapore currency (set up ACU only)
- Relax conditions governing entry of expatriate professionals
1971
- Monetary Authority of Singapore (MAS)
- Central bank of Singapore
- Minimal as compared to HKMA
- Conduct monetary policies
- Regulate banks, insurance and stock market
- Unified regulator
- Comparisons of different regulatory structure in different jurisdictions
1973
- Abolishment of Bretton Wood System
- S$ floated, no longer linked to any currencies
- MAS conducted open market operations
i.e. sell S$ against USD to enable S$ gradually escalate against USD steadily
1975
- Abolishment of Cartel system (a system to set fixed exchange rate)
1978
- Gold Exchange of Singapore (GES) established
- Failed because no real demand for commodities
- Commodity Futures Exchange and Financial Futures Exchange
1984
- GES converted to Singapore International Monetary Exchange (SIMEX)
- Commodities Exchange of HK converted to HK Future Exchange (HKFE)
- Both are future securities exchange
- SIMEX
- Not related to Singapore market, focus on non-SD-related market
- Much more varieties than HK (HK only has Hang Seng Index Future)
- Speculators can use Hang Seng Index to speculate but cannot use
SIMEX

- Consists on Euro dollar future, Euro Yan futures, N225 Futures, TW index
futures
1987
- Stock Exchange of Singapore Dealing and Automated Quotation
(SESDAQ)
- For small companies not big enough to be listed in stock exchange
- Do not have 3-year record
- For foreign companies
- Similar to HK Growth-Enterprise Market (GEM) in 2000
1990
- 1965, Malayan Stock Exchange separated into Malaysia Stock Exchange and
Singapore Stock Exchange
- Companies listed in both stock exchanges
- Singapore Stock Exchange is more sophisticated
∴ most trade is done in Singapore
- Malaysia passed a law banning Malaysian companies trading in foreign
countries. Malaysian Companies had to be listed in Malaysia first
→ take away half volume of trading
1990-1997
- Central Limit Order Book (CLOB)
- A computerized system
- For all foreign countries to trade in Singapore
- No need to be listed in the Singapore stock system as long as registered
- Bring bank Malaysian companies and other foreign banks
1998
- Physical settlement in the past
i.e. buy a share, get a physical script
- Singapore and HK went to Central Clearing and Settlement System (CCASS)

increase volume of settlement
- Trade is done via CLOB
- Malaysia also employ CCASS
- Malaysia settlement system did not recognize a transaction until it was
done in Malaysia Stock Exchange. Otherwise, title cannot be transferred
from seller to buyer

- This hurt CLOB system
- Singapore stock market cannot grow anymore
- ∴ Singapore stock market is small than HK after 1990s
- Most of the large companies already listed → depends on outside
1999
- SIMEX merged with Stock Exchange of Singapore (SES)
- Become Singapore Stock Exchange
- HK Future Exchange merged with HK Stock Exchange in 2000
Financing Institutions in Singapore

5 Major government-related financial institutions
1. Monetary Authority of Singapore (MAS)
- Central bank of Singapore
- Monetary policy maker
(1) Formulate and implement Singapore monetary and exchange rate policy
too keep Singapore exchange rate from fluctuating too much
(sell and buy SD against USD)
- HKMA do not have much power
∵ LRES, cannot have independent monetary policies
- Singapore has no LRES
- Manage float and allow currency to go up gradually but it is not rigid
- Allow to depreciate during Asian Financial Crisis
- More flexible than HKMA
(2) Regulator
- Regulate all markets, securities market
- More power than PBOC and HKMA
- In China, 3 financial institutions
(3) Banker and advisor of Government

- Government deposits in the central bank
- Issue government debt
- Help to borrow money from foreign agencies
- Manage foreign reserves
- Currency Fund is used to back up the notes and coins in Singapore
- Management of government reserve
- Tenasek invests part of the reserve
- Long term reserve are managed by Government Investment
Corporation of Singapore and Tenasek

- MAS managed short term and medium term reserves
(4) Issuance of currency and coins

- Merge with Board of Commissioner of Currency of Singapore in 2002
(5) Bankers to financial institutions

- Bank to other commercial banks
- Commercial banks has to open a clearing account in the MAS
- Singapore has minimum reserve requirement which can be changed
- Acts as a lender of last resort through the discount window
- Clearing and settlement purpose
(6) Clearing of domestic debt security
2. Government of Singapore Investment Corporation Private Limited

(GIC)
- in charge of the long term investment of Singapore foreign reserves
(together with Tenasek)
- invest more in non-listed company → less liquid
3. Post Office Savings Bank (POSB)

- set up in 1972
- redundant
- Merge with DBS in 1998
Controlled by Government – the major shareholder
Largest bank in Singapore
private + public owned bank
4. Board of Commissioner of currency of Singapore

Merge with MAS in 2002
Currency fund merge with MAS foreign reserve
5. Central Provident Fund (CPF)

- Established in 1955
- HK: Mandatory Provident Fund in 2000
- Difference of CPF and MPF:
1. Central management in Singapore
- In HK, each employer choose MPF management companies
2. Singapore, employer 20%, employee 20%
- In HK, employer 5%, employee 5%

3. Primarily invest in government securities
- very low risk
- In HK, wide variety of stock, bond, blue chips, money market funds, capital
protected funds
4. Can withdraw CPF before retirement for housing scheme and insurance
- In HK, not allowed to take out until retirement
- Workers are allowed to withdraw funds to invest in stock
- Investment Scheme:
- 1978, Singapore Bus Service (SBS) Share Scheme
Allow withdrawal of CPF to invest in SBS
Easier to raise bus fares because widely owned by citizens
- 1986, Approved Investment Scheme
invest in approve stocks, gold
in order to boost the stock market and attract foreign investors
- 1999, Asian Financial Crisis
CPF member lost money
Restrict investment in unite trusts and funds only
5. Can only withdraw half of the CPF when retirement at 55
- In HK, can withdraw all
- Can withdraw fixed sum per month when 62 at S$790/week
- Can offset your apartment against minimum sum and withdraw all funds
Private Financial Institutions

HK Singapore
Full Licensed Banks Commercial Banks Full banks
(local 6, foreign 24),
Wholesale banks (40),
Offshore banks (45)
Restricted Licensed BanksInvestment banks Merchants Banks(49)
Deposit-taking companies Finance companies Finance companies (3)
Full banks
- Allowed to do everything a commercial bank does
- Make loans, deposits
- Offer all kinds of accounts
- No restriction on the size of deposit

- Local: beneficiary ownership, owned by Singaporean
- 6 local banks belong to 3 major groups
- DBS: Development Bank of Singapore
- Government bank, merged with POSB
- Biggest bank in Singapore
- Listed in HK and Singapore
- Islamic Bank of Asia (absorbed)
- OCBC: Overseas China Banking Corporation
- Bank of Singapore (absorbed)
- UOB: United Overseas Bank
- Overseas Unit Bank (absorbed)
- Foreign full banks:
- 6 of them enjoy Qualifying Full Banks privilege (QFB)
- Can have office in 25 locations
- Can have ATM machines serving more than 1 banks
- Other can have office in one building only
Wholesale Banks
- None in HK
- Do mainly long term deposits
- Restrictions:
1. No saving accounts in SD or foreign currencies
2. No interest bearing current account in SD when the customer is a
Singapore non-bank resident (Singapore corporation/individuals)
to protect the Singapore retail business
can offer interest for foreign customers
3. SD fixed deposits > SD250,000
4. When issue SD bonds, maturity must be >1 year, and size of
denomination must be >SD 200,000
can only serve sophisticated wealthy people, not compete with retail business
5. Only one place of business in Singapore
Offshore banks
- All the restrictions on wholesale banks
- Other restrictions
- Cannot offer SD fixed deposits for Singapore residents customers of any
size
- May operate current accounts with customers which have other
dealings with the bank (not to new customers)
- Total credit facilities in SD granted to Singapore residents must be <SD

500m to protect local business
only allowed to take offshore business
Merchant banks
- Corporate finance, underwriting, merger and acquisition advices, portfolio
investment management, management consultants
- Compose of 2 units: Domestic Banking Unit (DBU), Asian currency Unit
(ACU)
- DBUs must not accept savings from the publics, only from banks, finance
companies, shareholders
- Cannot do Singapore retail business
- Raise money by issuing notes, CPs, CDs, borrow from banks, finance
companies, shareholders
Finance companies
- Small scale financing: installment, credits for cars, consumer durables,
mortgage loans
- Restrictions:
- No checking account deposits
- Cannot deal in foreign exchange and precious metal business
- Cannot grant required loans >SD5000 to any person
Institutions with ACU (157)
Only 4 DBU do not have ACU
DBUs
A L
Amount due from banks 34% Deposits 55%
Loans 39% Amount due to banks 27%
ACUs
A L
Amount due from banks 59% Deposits 29%
Loans 21% Amount due to banks 59%
- ACUs
- Do primarily offshore business
- Attract foreign banks to invest and invest in foreign banks
- DMUs
- Much more retail-oriented
- ACU assets = 2.2 x DBU assets
- Foreign banks assets = 2.9 x local bank

∵ local banks almost purely DBUs
Foreign banks – DBUs + ACUs
- Property related loans (building + construction, housing, bridge)
DBUs = 47% of total loans
ACUs = 5% of total loans
Singapore has statutory control of liquidity

- Larger external debt → more vulnerable for domestic currency
- In Singapore, total asset slightly > total liabilities
Positive external asset
→ not vulnerable on domestic currency

Singapore’s securities and futures markets
Future market
Singapore International Monetary Exchange (SIMEX)
- Counterpart of HK Future Exchange in 1996
- Commodity type exchange
Gold exchange
Not successful because no real uses for commodity future
- Do not include any Singapore related product
- Protect the currency and stock market
- Prevent the speculator attack the domestic market
- Different from HK Future Exchange
Hang Seng Index is the dominant product
Most of them are HKD related
Singapore exchanges
NK + TW = 83% of volume
NK
- Biggest market
- First one to start Nikki 225 Futures
- Arbitrage opportunity as 2 markets selling the same product
- Osaka also has N225 Futures
- 1984, big success
- 1986, Japan followed to offer N225, increase exchange in Singapore
- Banks short the higher price index and long the lower price
- 1994, Kobe earthquake, NK collapse
- Pressure to merge
TW
- Taiwan Index Futures
- HK, Singapore, Taiwan, Chicago started trading the TW almost at the same
time
- Big success in Singapore
SG
- MSCI Singapore Futures
- 3rd largest in volume, but much lower than NK and TW
- The only Singapore-related

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Overview of the Hong Kong Banking System, the HSBC

Group, the Bank of China Group

Authorized Institution (AI) Restriction by Type

Abolishment of Interest Rate Restriction

no restriction on min denomination & term to maturity

Asian Financial Institutions - 1

Central Bank of China: People’s Bank of China

Restricted Licensed Banks

Local Representative Offices

Asian Financial Institutions - 2

2. Banker, agent and advisor of the Hong Kong Government

Asian Financial Institutions - 3

4. HSBC chairman was automatically a member of the Executive

Hong Kong Interbank Clearing Limited

HSBC BOC SCB BEA Citibank

Pre 96 – Net Settlement System

Asian Financial Institutions - 4

In HK, there is NO Minimum Reserve Requirement (used to regulate liquidity of

HSBC BOC SCB BEA ….. [10 settlement banks]

Between 7/88 – 12/96 (Net Clearing Balance = Sum of clearing accounts)

B was determined by EF.

HSBC BOC SCB BEA ……

Asian Financial Institutions - 5

HSBC BOC SCB BEA Citibank

Asian Financial Institutions - 6

(RMB) (HKD) (USD) (Euro)

2003, a system for Euro was set up,

- PvP (Payment vs. Payment) (Cash to Cash)

- DvP (Delivery vs. Payment) (Security to Cash)

Settlement institutions simply take instructions from clearing houses.

Asian Financial Institutions - 7

Why need regulations?

Liabilities of a bank: Deposits Rather short term

Usually, a central bank would lend money to a troubled bank so as to restore

Asian Financial Institutions - 8

3. Product Line Control

Asian Financial Institutions - 9

In US, Glass-Steagull Act (1933)

Liquidity Liquefiable assets >

- Liquefiable assets: assets convertible into cash within 1 month

b. Capital adequacy ratio

Asian Financial Institutions - 10

Off-balance sheet items:

Asian Financial Institutions - 11

4. Banking Ordinances restrictions

Asian Financial Institutions - 12

3. Advances to directors and relevant persons of the AI

6. Holding of shares in any company or companies with value over 25%

Way to avoid: have 24-hour banking all over the world

Asian Financial Institutions - 13

1. Exchange Fund Bills

Conventional Loan (Commercial bank)

Companies prefer to choose debt securities

Asian Financial Institutions - 15

3. Short-term Negotiable Certificate of Deposits (NCD)

Source of financing Cost of funds Use of funds

HIBID: Hong Kong Interbank Bid Rate 港元銀行借入利息

BLR: Best Lending Rate (Prime Rate) 最優惠利率

Asian Financial Institutions - 16

- If HIBOR < Deposit Rates, banks would engage in Interbank borrowing,

HIBOR is set by the big banks. Small banks have no control.

HIBOR can be > BLR

Asian Financial Institutions - 17

Non-bank Retail Bank